Tuesday, June 19, 2012

The Painful Impact of Ultra-Low Interest Rates

We are all quite aware that we are living in an ultra-low interest rate environment thanks, in large part, to the creative efforts of the world's central bankers.  This environment was created in response to the near collapse of the world's economy during the Great Recession and has been carried forward into the third year of the so-called "recovery" as a desperate means of stimulating a rather sick world economy back to health.  Thus far, the response of the world's economy to all of this cheap credit has been a resounding and reverberating "Meh".

Just so we can get a sense of how low interest rates really are compared to historic norms, here is a graph showing the benchmark interest rate for the United States since 1972:

Here is a graph showing the benchmark interest rate for the United Kingdom since 1972:

And, finally, here is a graph showing the benchmark interest rate for Canada since 1990:

While the central bankers of the so-called "developed nations" ponder why the world's economy seems so unresponsive to all of their machinations, there may be an explanation.  While this particular posting pertains to details about the issue in one nation, the same cause-effect relationship applies to all nations that are currently experiencing near-zero interest rates.

UHY Hacker Young, a United Kingdom-based accounting firm, has released a study showing that low interest rates are responsible, in part, for damaging the economy.  UHY estimates that the combination of high inflation (a United Kingdom Retail Price Index (inflation rate) of 3.5 percent) in combination with near-zero interest rates on savings and current accounts has resulted a decline in the value of the nation's savings.  UHY estimates that U.K. savers are losing nearly £18 billion per year as inflation erodes the value of their savings, even on higher interest savings accounts and longer-term locked-in investments.  While I realize that this data is specific to the United Kingdom, the same issue faces savers in Canada, the United States and other nations where interest rates are at or near historic lows.

The Bank of England reveals that over £115 billion is currently deposited in U.K. bank accounts that are yielding zero percent interest.  To put this number into perspective, these savings work out to just over 7.5 percent of the United Kingdom's GDP for 2011.  Since smaller investors experienced frightful capital losses during the stock market collapse of 2008 - 2009, many retirees, in particular, are cautious about seeking the higher returns that could be available by investing in equities.  Many would prefer to see their real net worth drop as inflation slowly eats away at their nest egg rather than to suffer from the sudden shock of a cliff-like decline in the stock market.  Despite historically low returns on savings, the United Kingdom household savings ratio was 7.7 percent in the fourth quarter of 2011 and 7.4 percent for all of 2011, up from 7.2 percent in 2010.

With no return on relatively risk-free savings, savers are much more likely to spend less.  Since much of the developed world's economies relies on consumer spending for continued growth, cutbacks in household spending on all of those wonderful toys and other non-essential items will be curtailed, ultimately having an impact on economic growth around the world.  This is a prime example of the law of unintended consequences; central bank actions may actually be hurting the economy rather than helping it.  

Thanks to QE, banks around the developed world are getting away with paying savers very little or nothing for their savings, generally offering rates that are well below the rate of inflation.  This means that your savings today are worth less in the future as inflation quickly eats up any investment income.  On the upside for the ruling class, extremely low interest rates mean that governments around the world can continue to spend far more than what they are bringing in because the interest owing on their debt is not punitive....at least, not yet.


  1. This is 'financial repression' and is not new. That fixed income savers suffered in the past when governments ended up with too much debt is clear from the past. In an earlier age, the sovereign merely defaulted. In the 20th Century--and now again in the 21st Century--they engaged in keeping interest rates artificially low so that there was a negative real rate of return. As debt is mostly in nominal terms this is a write down in real terms. As you correctly point out, this is hurting many sections of society and, possibly, also hindering an economic recovery.
    An interesting hypothesis is doing the rounds that firms, who might be in a position to invest, are holding off because they are suspicious of the unnatural economic conditions. So -- as you rightly point out -- central banks acting to cut interest rates to near zero and engaging in QE might be part of the problem. And it is not as if we do not have a precedent of the perverse effects of financial repression in Japan, which has flatlined since its economic bust, nearly a generation ago!

  2. Thanks for your input Paul. Interesting point about writing down nominal debt. I agree about Japan - they've had nearly a decade of QE and look where that has got their economy!