Why Are Interest Rates So Low? What You Need To Know 1
According to Milton Friedman, low rates = not enough money and high rates = too much money.
After all, conventional finance/economic thinking states that interest rates are lower when money supply is higher.
Their logic is that with more money in the system, lenders compete to make loans by lowering the interest rates that they ask for. Conversely, when money is tight in the system, lenders raise the interest rates they charge since they can charge more for what is scarce.
Unfortunately, this line of thinking is inaccurate. It also happens to be one of the most widespread misconceptions held by financiers and economists.
The main reason for this inaccuracy is that it views interest rates as only representing the price of money. This is a consequence of a Central Bank-centric perspective, where people think that because the Central Bank sets interest rates, the price of money is all that matters.In other words, if the price of money has already been set low, but people are still not buying, then the price is not low enough!
This view fails to consider the other side of the equation, in this case, the borrower’s perspective. Here’s a simple example. A new business thinks it can get a return of 5% a year, and goes around shopping for a loan.
If the interest rates banks offer to it are lower than 5%, will the business take the loan? Yes.
If the interest rates banks offer are higher than 5%, will the business take the loan? No!!
Therefore, interest rates don’t just represent the price of money, they also include borrowers’ expectations of future returns.
Look back at previous bull markets, where economic conditions were also ebullient. In the dotcom mania years of 2000-2001, the US prime rate peaked at 9.5%; the mega bonus Wall Street years leading up to 2008 saw the same rate peak at 8.25% in 2006.
Both instances saw people borrowing money at rates which are, in today’s zero/negative rate environment, exorbitantly high, because they were expecting returns that were higher than those 8% – 9% rates.
Now, from this perspective, what do historically low rates in the world’s developed economies say about how businesses/investors view returns in today’s economic environment?
Historically low, of course!
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