5 Problems With Ultra-Low Interest Rates

Low interest rates can be great. The Federal Reserve absolutely loves them. To curb unemployment, it stimulates the economy by keeping interest rates very low for a very long time. The federal funds rate has hovered just above zero since December 2008. This short-term rate defines the cost of lending from bank to bank through the Fed and serves as a benchmark rate for the economy. The Fed has also taken measures to keep longer-term rates low, by purchasing huge sums of longer-term Treasury notes. Some trouble consequences follow from these low rates, however.

Saving Becomes Unattractive

The Fed likes low interest rates, in part, because they strong arm cautious consumers to spend more money or to invest. If a savings account provides an interest rate that rounds to zero percent, then saving becomes illogical. After all, you may actually lose money by saving, if inflation rises faster than the interest you earn on your savings.

When more people spend and invest, the economy expands. That's what the Fed wants in these situations. But every dollar consumers spend instead of saving amounts to several dollars that would have been available in the future if it had been earning interest instead. As low rates discourage people from saving for years on end, they must become more and more reliant on government entitlements in old age.

Saving Becomes More Difficult

What about those people determined to save? Nonexistent savings account interest rates might not deter them if they insist on having money put away for old age or a stormy day. Managing to save effectively becomes much more difficult when interest rates are very low, however.

As just mentioned, if rates are low enough, then they might not even beat inflation. For example, imagine if your grocery bill costs $100 now and the same basket of food costs $102 in a year. Inflation was 2%. But if your savings rate was just 1%, then saving $100 would only provide you with $101 a year later -- you couldn't buy the same basket of groceries.

This forces savers to turn to other, riskier alternatives. These often include stocks, bonds, or funds. While these can be good investments, the average person might not be particularly savvy in knowing how to invest wisely. This can result in either an added cost for the need to hire an investment adviser or lost money if poor investment decisions are made on one's own.

Bank Deposits Sink

Once upon a time, banking was very boring, but relatively stable. Customers put their money in savings accounts, on which banks paid them interest. Banks would then use those deposits to provide loans to other customers, who they charged a higher interest rate. The difference between these two interest rates would cover any losses on those loans. Whatever was left over would be the bank's profit.

Today, even if a bank wants to operate that way, it's much more difficult. Savvy people leave a small sum of money, only what they may need immediately liquid, in their checking accounts. This probably amounts to a few thousand dollars for most people. Any excess should be invested or saved. When saving rates are too low, people must turn to investing.

With so little in savings accounts, and checking accounts kept as small as possible, banks often aren't left with enough deposits to support their lending activities. This forces them to either borrow more, which creates additional leverage, or sell their loans through mechanisms like securitization. While both of these activities can be perfectly safe, they can also lead to problems if not conducted carefully. Both excessive leverage and poorly executed securitization were major factors that contributed to the financial crisis.

Encourages Debt

And as low interest rates drive down bank deposits, they also increase the demand for loans. Lower interest rates encourage firms and consumers to take on more debt. For example, as a firm ponders expanding, a low rate environment might create a once-in-a-decade opportunity to finance equipment very cheaply. From the consumer standpoint, a lower interest rate might allow a family to purchase a more expensive home than they could afford in prior years, without increasing their monthly mortgage payment.

What's so bad about debt? Again, nothing if it's taken on prudently and in moderation. But low interest rates can cause excess. This can be especially dangerous if a loan obtained in a low interest rate environment is not fixed, but adjusts as rates rise. Suddenly that loan may quickly become unaffordable. But even fixed rate loans can be a problem. If that family in the example above suddenly needs to move due to a new job opportunity, it might be significantly more difficult to sell their house once rates have risen, as potential buyers will have to be relatively more wealthy, since the higher interest rate leads to a higher monthly mortgage payment.

Investors Pursue More Risk

Finally, low interest rates force investors to pursue more risk. This has already been mentioned generally, in regard to the relative attractiveness of stocks over interest-bearing investments. But the rule also applies to bond investors.

Bond investors may have certain interest rate targets they aim for as a part of their investment objective. If rates sink too low, then those yields might be harder to obtain. To do so, they have to look for riskier securities. We have seen this phenomenon recently as investor interest has resurfaced for subprime mortgage-backed securities.

The Fed may have good and honorable reasons for pushing interest rates very low. But when they're left there for an extended period, distortions can begin to creep into the economy. Do the benefits outweigh the costs? It depends on your perspective.