Low Interest Rates: Too Much of a Good Thing

Negative interest policies encourage savers to keep their money in cash rather than put it in the bank. If my son was faced with the choice of keeping the $100 at home or putting in the bank, and, after one year, having $99.50, he would keep the money at home. But money at home has no velocity or productive use, it just sits there. Negative rates also signal economic challenges in the future, decreasing the desire for risk-taking.

Brian Wesbury, chief economist at First Trust, points out negative rates have generated demand in the economy for one product: safes. According to Wesbury, "there is a shortage of safes in Japan as consumers try to get cash out of banks where they may be charged interest, instead of receiving interest, in the future. At the margin this is happening in Europe as well. When people hold more cash, banks have fewer deposits, so the idea that these negative interest rates will force banks to lend and expand the money supply is suspect." Inflation Struggles

Based on the first two points, the effect of negative rates may be to deter growth and reduce inflation. If the economy heals in spite of central bank policy and begins to create inflation, then the banks must raise rates. But the low rates have created an environment where a rate increase may be destabilizing. This leads us to the third challenge: Banks will struggle to control inflation effectively.

Michael Ashton, principal at Enduring Investments, points out that uniformly low rates provide little incentive to move money to higher-yielding opportunities. As rates rise, savers will be more focused on maximizing the value of their cash and putting cash into the system. Banks will be willing to lend. Thus the early interest rate hikes will likely increase economic activity (and inflation) when they are supposed to be slowing it down. Higher unexpected inflation increases the risk of a market shock and reduces the value, directly or indirectly, of many investments.

Central banks condition investors to believe they are coming to the rescue, leading investors to take on additional investment leverage that will unwind painfully. Because inflation may increase during the initial hikes, rates may have to increase quickly, pushing markets lower.

A Balanced Approach

Ongoing efforts by central banks to save the economies aren't working, and they create an illusion of action that pulls pressure from politicians to make needed reforms, such as creating incentives and laws to keep baby boomers working. If these reforms had been made in 2010 or 2011, we could be reaping the benefits of them now.

The alternative is the admission, at a great moment of difficulty, that the cuts have been too much of a good thing and need to be undone. This is what happened to Pooh. He went on a week-long diet until he had shrunk enough that Christopher Robin, Rabbit, and all Rabbit's relatives and friends, were able to pull him out. Better to have stopped eating the honey earlier.