The risks of low interest rates

Low interest rates are a blessing for those buying their first home. Photo: Jason Borg

Low interest rates are a blessing for those buying their first home. Photo: Jason Borg

Central Bankers believe that low interest rates are the best weapon they have to fight the current global economic slump which is inflicting misery on millions of people. Interest rates are at an all-time low and, in most cases, real interest rates are negative and therefore not even compensating bond investors and bank depositors for the cost of inflation.

Savers and borrowers need to manage the risks of low interest rates if they want to prosper
- John Cassar White

Low interest rates have some positive effects, but if maintained for too long, they can cause much damage to both individuals and businesses. Admittedly, low interest rates are a blessing for those buying their first home. The property boom that persisted in most European economies in the last two decades has meant that many first-time buyers bought properties that were priced beyond what they could afford to repay. They mostly did this in the belief that the capital appreciation as well as the prospects of improved income would make their repayments affordable and their investment in property foolproof. Those who over-invested in their home are at least benefitting from unusually low interest rates even if their income may not have increased as much as they thought they would.

I do not believe that businesses are benefitting all that much from the low interest rates being charged by banks. The real problem being faced by businesses today is a dramatic fall in demand as consumers fear for their future and cut down on their spending. Indeed, the real risk is that some businesses will be tempted to get involved in speculative investment in property believing that property prices could not go any lower. Banks should be more careful about where the money they lend to businesses is being spent. They should also build their provisions for doubtful debt as the worst effects of the current recession on businesses may still not have been felt.

The most worrying aspect of low interest rates is the negative impact it has on investors, especially those who depend on the interest they earn on their bond holding or bank deposits for meeting their living expenses. With investors often receiving negative yields on their conservative investment products, the temptation to invest in higher yielding but much riskier financial products is often irresistible. Unfortunately, such decisions at times end up hurting investors who have a low risk tolerance by depriving them of part, and sometimes all, of their capital.

There is no simple solution to the current low yield phenomenon that is affecting investors who have put their money in investment grade bonds and bank deposits. My advice to people with a low risk tolerance is that in these times capital protection should be their top priority when considering where they intend to place their hard-earned cash. One also needs to be careful as some of the bank deposits on offer locally seem to be offering interest rates that are suspiciously high. While the deposit guarantee scheme should give a degree of reassurance, one would still expect the financial services regulators to be vigilant and protect investors from certain banks’ possible high risk business models.

Another negative effect that a low interest rate regime may bring about is a lowering of the propensity to save for those who really should be thinking about saving more for their retirement. The personal finance media has for a long time been sounding the alarm bell that younger people are not saving enough for their retirement.

With governments more focused on tackling short-term economic priorities, the issue of the inadequacy of pensions has been put on the back burner in most countries. Younger people who are still two or three decades away from retirement make the pensions’ inadequacy problem more serious by practically ignoring that it even exists.

Inertia is young people’s worst enemy in their quest to plan for their retirement.

While the prospects of high inflation in western economies are quite subdued as a result of a fall in consumer demand, no one can guarantee that oil and other commodity prices could not cause a bout of high inflation in the medium term.

The easy monetary policy that persists will need to be reversed very quickly if inflation rates pick up. If and when this happens it is bound to shock borrowers who are getting used to a low interest rate regime.

Savers and borrowers need to manage the risks of low interest rates if they want to prosper.

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