By Tim Courtney, Chief Investment Officer
In early March, the Bank of Japan increased its interest rate by 0.1%.1 While this increase might appear minimal, this was a significant move because it marked the end of an era of negative or zero interest rates. You might be thinking that the concept of zero or negative interest rates seems extremely bizarre — and we think in most cases it is. Let’s explore two key reasons why positive interest rates are necessary for economic systems to function well.
Firstly, and most obviously, interest rates compensate us for the time value of money and the risks of default and inflation. We have recently been re-introduced to the necessity of interest rates being high enough to compensate lenders for inflation risk. Although the risk of default for central banks in Japan, Europe, or the U.S. is low, it is not negligible. As recent developments in the U.S. have shown, this risk is escalating due to deteriorating fiscal health.2 The concepts of no-cost debt and a “free lunch” should sound strange to people with enough experience to know that free lunch outside of charity doesn’t exist.
The second reason to maintain positive interest rates is to uphold the general rules governing our global financial system. Central banks act as referees in this system, setting interest rates and controlling the money supply to ensure fair play and prevent imbalances. A positive interest rate enforces these rules by establishing a cost for money, compelling participants to carefully consider the financial implications of borrowing. This helps maintain balance within the system, discouraging risky use of capital and preventing funds from being channeled into less productive or even counter-productive areas.
When central banks in Japan and Europe previously lowered interest rates to zero or even into negative territory, they upended norms and created unusual incentives. As savers and investors, we were negatively impacted by this period of zero or negative interest rates. While interest rates in the U.S. never reached negative levels, we still faced very low rates over the past decade. During the decade of 2013 to 2022, a period following the Great Financial Crisis in which central banks kept rates low or negative, bond markets returned 1% while inflation averaged 2.6% annually. This represents a cumulative purchasing power loss of almost 20% over that decade for lenders. This is to say nothing of the default risk investors took.3
This situation fostered an environment that favored risk-taking over saving and lavish spending and investing on projects with dubious value. Looking back, especially at the negative interest rate environment in Europe and Japan, it’s difficult to make the argument that this approach significantly enhanced economic opportunities. As we approach the height of election season, there will be mounting pressure from all sides to lower interest rates. For bond investors, reducing rates while inflation and default risks are steadily rising is not attractive. The central banks should be unbiased referees to keep the economic game fair. If you have any questions about the impact of interest rates on your portfolio, please contact your financial advisor.
Sources
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