A recent Twitter discussion I was involved in was focused on whether or not central bank interest rates (including the US Fed’s) were being set with a view to punishing investors and savers. I was a bit surprised that there was even a debate, since to me the answer is pretty obvious: of course they are!
Now I have no doubt that when the process of setting central bank interest rates is under way, the folks in charge aren’t really thinking about punishing or aiding anyone. Punishing savers isn’t really a mandate for any central bank, and I’m pretty sure the topic never comes up in the rate-setting discussions.
However, when a policy has an impact, even an unintended one, and that impact is consistent and easily foreseeable, does purposeful intent (or lack thereof) really make a difference?
The Twitter feud went to great lengths to delve into the nitty-gritty of Fed policies. However, I think that the answer is obvious just by looking at the reason why central banks lower rates in the first place.
Why Are Current Central Bank Interest Rates So Low Anyway?
When the economy is shaky and growth is cooling, the first instinct of central banks is to do whatever is necessary to support growth. They want to ensure a mere slowdown doesn’t turn into a more pronounced issue, such as a recession. The idea is to get money off the sidelines, so to speak, and working in the economy.
In the current post-2008 economic environment, growth has been attainable only with massive amounts of stimulus provided by central banks. This has been largely (but not entirely) through very accomodative rate policies. The idea is that dropping interest rates to near zero accomplishes two things: 1) it discourages savers who may decide that saving money isn’t worth the low return and so will spend their money instead; and 2) it encourages people and businesses to borrow and spend, since accessing credit becomes incredibly cheap.
This combined effect of a low-interest-rate environment gets money out of the hands of consumers and into the hands of manufacturers, distributors and salespeople. Economic growth is thus spurred and catastrophe is, theoretically, avoided.
And this isn’t a new process; economic cycles and the standard central bank response have been around for a very long time.
What Has Changed Recently?
The challenge today is that, for the last 40 years, overall interest rate trends have been in decline. As the chart below shows, since the high-rate shock of the early 1980s, each economic cycle has seen rates move lower and lower. This would appear to indicate a gradually weakening economic environment as continually lower rates are needed to stimulate activity out of a contraction, and expansionary periods are unable to tolerate what would have been “normal” rates in the previous cycle.
The uniqueness of the current period is not only in the fact that central bank interest rates have achieved an unprecedentedly low level, but in that they have stayed there for so long. In the 10-year recovery that has followed the Great Recession, rates only managed to come back to just less than 2.5%, and now they are on their way back down again.
The oddity of these times is seen in the fact that, as I write this, mortgages in Denmark are being issued with a NEGATIVE interest rate. That’s right, the bank is essentially paying you to take out a mortgage! (More information can be found here.) This is not the hallmark of a healthy global economy.
Why Do I Care? Why should you?
Central bank interest rates directly impact the rate of return on short-term savings vehicles, such as savings accounts and term deposits. However, they also have a significant, if less direct, impact on bond markets. This creates a sizeable challenge since ultra-low central bank rates often mean that savers and investors cannot achieve a “real” return (a return in excess of the rate of inflation) in fixed-income instruments.
This inability to generate a “real” return leaves people with two choices: 1) do what the central banks are trying to encourage you to do, which is borrow and spend; or 2) adjust your investment methodology to take on potentially more risk by investing in things that have a better chance of generating a “real” return, such as stocks.
Fight The Good Fight
In the environment we live in today, there are so many pressures to do the wrong things financially. We are constantly being pushed to accept a new credit card, or to purchase something we don’t need with “low monthly payments”. We are told that we “deserve” a new car, a new house, or a high-end vacation. On top of all this pressure to spend money we don’t even have, now we see central banks making saving seem pointless and spending easy.
In the face of all this, it’s important to keep one critical point in mind: you are the only one who will bear the consequences of your decisions. Not your country’s central bank, not your personal bank, and not the credit card companies. Do not allow pressure, or the challenges of maintaining an appropriate savings or investment strategy, to lull you into a sense of complacency. Do not abandon the good habits you’ve instilled in yourself simply because they seem out of fashion at the moment.
Keep making good decisions when it comes to your finances: avoid unnecessary debt, earn more than you spend, and invest the difference. Doing this consistently will keep you on a path to financial independence and a calmer, fuller, more flexible existence.
Important Disclaimer: the information above is for general informational purposes only and does not in any way constitute an offer for the purchase or sale of any security and is not intended to be considered comprehensive or personalized financial or investment advice. themoneygeek.info assumes no responsibility for the use or application of this information. Always consult a tax, investment, or other appropriate professional before adopting any new financial strategies.
I am an accredited Financial Planner with 23 years of experience in the financial services industry. During the course of my career I completed hundreds of financial plans and recommended and sold hundreds of millions of dollars of investment products. I believe that financial independence is a goal anyone can aspire to and I am passionate about helping others to live life on their own terms.