Former Federal Reserve chairman Alan Greenspan once said that there wasn’t much that central bankers could do about asset-price bubbles because it’s too hard to spot them until after they have burst.
Near-zero interest rates are driving investors to search for meaningful returns on their money by piling their cash into higher-risk investments. Sales of everything from corporate bonds to structured products that use derivatives to boost returns are soaring. Commodities, mergers and acquisitions, government bonds—all are attracting inflows of cheap money.
Central banks in Europe and the US were right to lower borrowing costs in response to the credit crunch two years ago. But these levels are now seen as normal. Federal Reserve chairman Ben Bernanke, Bank of England governor Mervyn King and European Central Bank (ECB) president Jean-Claude Trichet should recognize that markets are going haywire and that they could easily deflate these bubbles before it is too late.
Global interest rates are at record lows. In the UK, the benchmark is 0.5%, the lowest since the Bank of England was founded in 1694. In the euro area, the main refinancing rate is 1%, the lowest in ECB’s short history. In the US, the Fed slashed rates to a record 0.25%.
Not only are rates almost nothing, they have stayed that way for a long time. The ECB and the Bank of England have kept the same rate since the first half of last year; the Fed hasn’t changed its benchmark since December 2008.
Initially, low rates were seen as an emergency measure: a temporary cut to deal with an extraordinary crisis. But 18 months isn’t temporary. Zero rates have become the new normal. There is more chance of finding little green men on Mars than there is of a major central bank boosting borrowing costs in the coming year. Another six months or so, and most of us will probably have forgotten that money we kept in the bank ever earned any interest.
And yet if economics has one simple lesson, it is that if you change the price of something, you change behaviour as well. Sure enough, interest rates close to zero are changing the way people use their money—and not necessarily for the better.
There isn’t much point in keeping money in cash when it doesn’t earn anything. Instead, people are looking for anything that delivers some kind of yield.
Sales of junk bonds are soaring—and so are the prices. Companies have issued a record number of non-investment-grade bonds in 2010, according to Bloomberg data. Such debt issuance in the US has jumped to $200 billion (Rs8.94 trillion) this year compared with $106.1 billion in the same period of 2009. If your credit rating isn’t that great, there has never been an easier time to raise money on the bond market.
Likewise, sales of bonds known as structured notes, which use derivatives to increase the yield for investors, were up 58% in the year through August, according to Bloomberg data, even though they often aren’t suitable for private investors.
Those are just two ways the market is being distorted. It is happening in other places as well.
There is plenty of life in the mergers-and-acquisitions (M&A) market. And why not? If executives can borrow money for next to nothing, and sell all the junk bonds without a serious credit rating, why not go out and buy a competitor? It’s easier than building market share with better products and cheaper prices.
Low repayments forever
In countries such as the UK, the property market remains suspiciously resilient. Again, why shouldn’t it? Initially, record-low rates were a windfall for home owners; monthly mortgage payments plummeted. Now many people own properties on the assumption they will be paying about 3% a year in interest on their mortgage—forever.
All these markets have gone bonkers. Among savers, low rates are creating demand for assets that don’t really belong in the portfolios of most ordinary investors, and are bound to collapse in price once money becomes more expensive again. Among property buyers, and in the corporate M&A market, they are lulling buyers into a false sense of security.
Slashing interest rates near zero made sense two years ago when the global financial system seemed on the verge of implosion. But the emergency has mostly passed. They are now more of a problem than a solution.
Central bankers may believe they are propping up demand. Maybe they are, to some extent. But they also need to recognize that they are distorting the market and creating new bubbles.
Even Greenspan would agree we have seen enough of those.
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