Five Ds: The Consequences of Ultra-Low Interest Rates
Herve Hannoun, Deputy General Manager of the Bank of International Settlements, articulated five ways in which the current global regime of low interest rates is impacting the world economy and they are far from positive. He boils the impacts down to 'Five Ds' and they break down as follows:
Disincentives: The interest rate is the price of leverage in the economy. With interest rates at ultra-low levels, governments are under no pressure to reduce their debt. Negative rates actually encourage them to borrow more. And if government borrowing becomes a free lunch, there is a clear disincentive for fiscal discipline.
Distraction: When financial markets are fixated on monetary policy (“the only game in town”), they are distracted from the real economic policy challenges of raising real growth potential and productivity through structural reforms. The distraction effect explains why the low interest rate environment has coincided with weak investment in the real economy.
Distortion: When the decisions of central banks in advanced economies become the main driver for prices in global financial markets – whether exchange rates, stock prices, bond prices and spreads, commodities or housing prices – they supplant the normal role of economic fundamentals in setting market valuations. Asset prices become distorted.
Disruptions: Prolonged ultra-long interest rates cause disruptions in the business models of financial institutions (banks, insurance companies’ pension funds, money market funds), implying substantial risks to financial stability. Insurance companies’ and pension funds business models are also put at risk by ultra-low rates. They may find themselves unable to meet fixed long-term obligations. Life insurance firms will be less able to meet guaranteed returns. And the free fall in the discount rates inflates dramatically pension liabilities, eating deeply into the solvency of pension funds.
Disillusion: As the promised results in terms of employment and growth do not and cannot materialise, the outcome could be disillusionment. Confidence in the market economy could be eroded by the realisation that the apparently flattering level of the nominal-long term interest rate (0–0.5%) currently observed in the core euro zone countries (some of which run a debt-to-GDP ratio approaching 120%) is the result of massive public intervention rather than market mechanism.
The risk of disillusion also looms large for households in the new world of low returns. Ultra-low or negative interest rates will add to their worries by making it difficult for them to build up enough retirement savings. Thus households are more likely to increase their savings rate than to reduce it. Negative rates on deposited savings – effectively a form of taxation – will feed the debate on the “financial repression” of savers.
True, some households stand to gain from low mortgage rates, but this benefit will accrue only to those who can afford to buy a house. Moreover, the positive effect of low mortgage loan rates is largely offset by the increase in property prices fuelled by ultra-low interest rates.