THE TRUE COSTS OF VERY LOW INTEREST RATES / THE FINANCIAL TIMES COMMENTARY & ANALYSIS ( A MUST READ )

The true costs of very low interest rates

By Caitlin Long

Published: August 11 2010 17:14

Markets tend to cheer falling interest rates. Low interest rates, however, can entail real economic costs that become evident over time.

During the earlier period of monetary stimulus, from 2001-04, many businesses made economic calculation errors that later led to losses. Examples include investments in housing, commercial real estate and mining exploration, as well as the provision of defined benefit pensions to employees.

Interest rates are the most important prices in the economy, according to Nobel laureate F.A. Hayek, because they reflect the collective time preference of individuals to consume either now or later. Accordingly, interest rates co-ordinate allocation of capital across the economy by signalling to businesses whether they should invest. Distortions in interest rates can cause “clusters of errors” in which large swathes of businesses unwittingly miscalculate at the same time.

Hayek observed that interest rate stimulus interfered with economic calculations, causing managers to invest in projects that would not otherwise have appeared profitable. Losses can subsequently materialise as customer demand fails to meet forecasts that were, in retrospect, optimistic. Long-term projects are highly sensitive to interest rates and are therefore more susceptible to such distortions. Pension obligations and long-term, capital-intensive projects are at high risk of miscalculation based on artificially low rates.

To illustrate, capital expenditures accelerated in such long-term businesses as residential real estate, commercial real estate and mining exploration after the monetary stimulus that began in 2001, but losses materialised after interest rate stimulus was withdrawn.

According to the Bureau of Economic Analysis, investment in residential real estate grew by 2.8 per cent in the fourth quarter of 2000, before monetary stimulus began in January 2001. Then growth accelerated to 6.6 per cent, 10.0 per cent and 16.9 per cent during the fourth quarters of 2001, 2002 and 2003, respectively.

On June 30 2004 the Federal Reserve began to reverse the monetary stimulus just as residential investment growth was peaking at 21.1 per cent. It then decelerated and two years later home prices peaked and housing sector losses began to materialise.

Another area in which many businesses unwittingly underestimated costs is defined benefit pension plans. The widespread pension problem facing markets today is mostly attributable to the decline in interest rates amid waves of monetary stimulus during the past decade. Pension liabilities grow as interest rates fall, reflecting higher present values of future benefit obligations. A dollar of pension benefit granted in 2000 is currently worth approximately $1.32, solely reflecting the drop in interest rates. When managers calculated the costs of providing defined-benefit pensions in 2000, they could not have anticipated that a series of interest rate stimulus programmes in the intervening decade would drive costs up by 32 per cent.

Companies generally set aside funds to cover these pension obligations. However, even if a company funded its entire pension cost in 2000, for example, its asset portfolio returns would probably not have kept pace with its rising obligation. The average S&P 500 pension portfolio earned a cumulative return of 22 per cent since 2000. In the example, the pension plan would hold assets valued at $1.22 to cover an obligation worth $1.32. The company bears responsibility to pay the difference.

Hayek observed that “clusters of errors” tended to happen after monetary stimulus sparked an investment boom. When boom turned to bust he urged quick recognition of losses to free capital trapped in bad investments so markets could redeploy it to better uses. Any further rounds of monetary stimulus to cushion the bust would only prolong the inevitable adjustment and distort economic calculation anew.

If Hayek were alive he would caution businesses to be alert for the formation of new bubbles, especially in long-term businesses in which losses may not yet be fully recognised and price signals may still be distorted. He would agree with the investment caution that businesses have exhibited in the face of artificially low interest rates, and advise corporate decision makers to be alert if a project appeared profitable solely based on interest rate assumptions.

Where might the costs of the current loose money show up over time? It is impossible to predict with certainty. But low interest rates for a longer period increase the likelihood that businesses will miscalculate. Early signs of an investment recovery are showing up in such long-term businesses as industrial and transportation equipment and machinery. We will soon find out whether this recovery is real or the beginning of another bubble.

Caitlin Long is head of Corporate Strategy, Capital Markets at Morgan Stanley

Copyright The Financial Times Limited 2010.