Zero rates for ever

Whilst the financial press continues to debate when the Federal Reserve and the Bank of England will make their first move on interest rates, we consider the possibility of zero interest rates being the “new normal”. Rampant inflation would be everyone’s immediate expectation. It is worth remembering Japan has lived with zero rates for over 20 years with no sign of inflation. Most of the developed world has lived with zero rates for nearly 6 years and inflation shows no signs of picking up. Who would have expected the ECB to introduce negative rates and the following month’s inflation rate to fall. Why inflation has not occurred, as many feared is debated constantly these days, the fact is, it has not.

Interest rate changes are designed to stimulate and slow down an economy, mainly to ward off inflation effects and smooth the economic cycle. If the economic cycle were now more of a slow grind as many expect, as opposed to the more volatile moves of previous years, then the need to control it would be less. 

Some of the positives to zero rates could be that it encourages long-term investment. Zero rates allow households to invest in new homes. It allows people to afford the technological revolution (e.g. internet) that continues to draw on our capital resources that is so vital to modern life. Lower rates can also help businesses set lower prices as they pass on part of their funding benefits. 

Governments are highly indebted, as we know, and just like individuals they would struggle with higher interest rates. Central bank interest rates are otherwise known as the “risk free rate”, one could therefore argue if it’s risk free why should you get a rate of return on it. Perhaps it’s right that one should only get a return on capital by reinvesting back into the economy. 

The point many would make is a zero interest rate policy would encourage undue risk taking, and by some it probably would. No matter what interest rate, we are likely to have individuals that take undue risk; others may take a more conservative attitude. The 2000s were a period of excess risk taking and rates were not zero during that period. One could argue that the thought of an end to zero rates is currently encouraging excessive risk taking. 

The likelihood is that rates will normalise back to more traditional level, or that is the consensus view and as we know consensus is not always correct. Central bank policy makers may one day come to the conclusion that zero rates are the only way the world can cope economically going forward.

Posted on August 6, 2014 .