The Danger of Zero Interest Rates

Asad Dossani
It amazes me how many people have come out warning against the Fed raising interest rates. For example, I read one article suggesting that emerging market currencies and stocks (like India's) will badly suffer if the Fed raises rates. A higher US interest rate will cause foreign portfolio investors to pull out their money.

Seriously? Are we made to believe that if US interest rates rise from 0.25% to 0.5%, then all of a sudden emerging market stocks will become unattractive? Foreign investors pull out of emerging market stocks if economic prospects for the country worsen. The level of US interest rates plays a negligible role.

And for all the talk about the dangers of raising rates, how about the dangers of zero interest rates? Well, I'm going to fill that void today. Here are three good reasons why zero interest rates are a problem:

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First, people take out too much debt. When interest rates are close to zero, there's a strong incentive to borrow too much. This holds true for individuals, corporations, and governments. We've already seen this occur over the last few years.

Conversely, low interest rates reduce the incentive to save. Many people think its a good thing if consumers spend more than what they've good, but I'm not one of them.

Second, asset prices become too high. Most of the warnings about zero interest rates and quantitative easing warned about the potential inflation that would result. It turns out that this never occurred. But instead, we got asset price inflation. Stocks, bonds, and real estate, all hitting new highs. Over time, this leads to large corrections and crashes. Much like what we saw during August.

Third, it reduces the effectiveness of monetary policy in the future. This is a subtle but important point. Suppose there's a large unanticipated negative economic event, like a new crisis. With interest rates already at zero, there's no room for maneuver. There's no room to lower interest rates in case things get really bad. By raising rates now, you allow yourself the opportunity to respond to a potential future crisis.

In the long run, zero interest rates are dangerous. It may have been sensible to have such low rates in the middle of the financial crisis. But no longer.

What do you think of zero interest rates? Share your views in the Club or share your comments here.

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8 Responses to "The Danger of Zero Interest Rates"
vijendra
14 Sep, 2015
The topic of interest rates is quite misleading. As a common investor I have doubts. Plz clarify me if I misunderstand things. If say interest rates are @ 10 for banks fix deposits, and on loans its 14%. Then normally we say, increasing interest rates will increase saving, thus allowing banks to have surplus money for lending, which boost economy. Now if we assume 1% interest on fix deposit, & 4% on loans, the same logic applies here too. In later case, people lose their tendency to save, in turn expenses goesup, so more money coming to market. Its again good sign. The only missing link in above case is , people tend to save in other means like gold or real state. What so ever the case may be, afteralll money is coming into market.Like 
Rajeev Arora
14 Sep, 2015
I always reasoned out that US rate increase will have a minimal impact on Indian markets but then I got into a little doubt on my logic when I kept on reading about it through various sources. Thanks Asad for stating your logical comments about this topic - you have helped me reaffirm my belief in my own logic :)Like 
narendramolparia
12 Sep, 2015
Frenetic search of BoJ and Fed for moderate inflation has not yielded results so far despite zero rates and QEs. Asset price bubble is limited to US equity markets. Even this is more due to massive buy backs rather than due to public participation. There is no danger of public lining up for cheap loans as memories of housing bubble have not faded. THe overall consumption level in US economy is still lower than that of 2007. If zero rate was to lead to dangers pointed out by you and were to play out it should have already been there at least in Japan. Moot point is that economies of US Japan China and EC all have gone to a point of no return by printing paper money and heavy Govt borrowings. This tilts scale against rate hike for simple reason that it may accentuate deflationary expectations. If this happens it will be impossible for US and Japan to service their massive debt. The only solution would be a default. Alternative is to cruise along the familiar course with a hope for a miracle to happen. Massive sovereign debt and deflation are incompatible. A rate hike in the present context has a greater probability of triggering deflationary tendencies. Like 
hoshang dehnugara
12 Sep, 2015
the whole write up is exellant and very true, i dont believe in zero int ratesLike 
sankaran
11 Sep, 2015
Why is it that Infra companies borrow heavily , when it is clear that such projects seldom return what the models project and it is heavily dependent on regulators whims and actions. Strangely the MNCs which invest also make same or similar mistakes. To my knowledge no Power MNC has made money in India. All this counterintuitively ( compared to what the above article says) at very high prevailing interest rates. What do these companies miss ? Like 
Venkat Srinivasan
11 Sep, 2015
First time some one has given a clear explanation of what is wrong with zero interest policy, at least I have not read them before. I hope sanity prevails and ALL central banks take note of. Dr.Rajan has been requesting other central bankers through IMF. Hope the message sinks in to the skulls of other central bankers and Governments around the world. To my mind 2008 financial meltdown was precipitated, partially by the insurance agents and the banks selling them subsequently by disguising them as great vehicles of prosperity. The other part was Allen Greenspan's policy of constant adjustment of interest rates that was responsible. This time the low interest rates of his successors along with the over valued stocks is going to cause the rupture. Since the world is merrily chugging towards the next crisis, even to me I sound like an alarmist for stating what I have stated above. Only God should put some sanity into the minds government and bankers to allow growth to take place over time. This time taken by the stock market will also give sufficient time for the value of the companies selling stocks to grow avoiding any collapse. The more the Central Banks try to prop-up the market the more quick bubble formation and subsequent crash. If the central banks continue this practice of constant adjustment of rates to keep market climbing, the cycle time for bubble formation and crash would becoming less and less until the day that the whole system will need immediate fixing for survival of the financial system as we know it today. Like 
krishna Murthy
11 Sep, 2015
Zero interest rate make investment worthless for the common people. No growth is expected. An small inflationary trend is good but mere inflation is like deathknell.Like 
KRISHNAKUMAR P
11 Sep, 2015
logic conclusion is may be correct, but market behaves based on sentiments and stories running around, as per 0 interest in US and other world economy should have been in shambles, but it is not with low interest rates Like 
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