A central bank is one of the most important policy institutions in any economy. Generally, a typical central bank controls the economy by changing the interest rate -sometimes also called policy rate, repo rate, fund rate etc- which, in turn, sets the benchmark for determination of domestic interest rates for retail investors. In general belief, a low interest rate environment is considered conducive for economic growth since it cheapens the cost of credit. A lower cost of credit means more consumption and resultantly more production especially for credit driven advanced economies.
Notwithstanding the positive aspects of low interest rate for boosting credit and thereby general demand, there is an equal negative impact on the opposite side of the coin i.e. Savings. Savings occupy a very special place as they are not only considered as one of the key engines of economic growth but also a funding source of financial intermediation –the process of generating and lending funds-.As a rule of thumb higher the savings, higher the potential for future growth. The preference for savings by people depends upon a host of factors including but not limited to: 1) Competitiveness of returns 2) Risk aversion and 3) Inflation etc. To elaborate the point so as to how a low risk environment adds to more risks, I will use Capital Asset Pricing Model –aka CAPM-. The traditional equation of CAPM divides the sources of returns in two broad categories i.e. a risk free return which could be earned at no credit risk and marginal risk-driven return on the market. Now suppose an investor (be it equity investor in a company or retail investor with asset divided in risk free and risk bearing assets) has a minimum target return of say Rt with risk free return being Rf and market return of Rm associated with the return of a specific benchmark (e.g. Bond, Equity, Currency or Commodity)
The CAPM equation of target return comes at
Rt=Rf+β (Rm-Rf) --------------------------(1)
Now one can modify equation 1 to get modified target return - the need to earn risk-prone return- which comes:
Now consider if Rf≥Rt , a risk averse investor with Rt≤Rf would not be willing to take excessive risk since the need Rf to earn risk-prone return is zero. This is particularly important for long term investors e.g. Pension Funds, equity investors and Endowment Funds etc since the interest rate is expected to remain volatile over the longer term so they usually set a return target for their portfolios. Availability of sufficient risk free return keeps a check on their downside risks at a given target return. Now consider that the Central bank -say Fed- starts to suppress the both long and short end of the curve –i.e. both short term as well as long term interest rates- by rate cuts, QE and Operation Twist and thereby fuels the “zero interest rate” expectations for n future periods (like recently market consensus remains that Fed would not start tightening before 2015-almost 8 years of zero risk free returns-) .
The equation for modified target return becomes
This indicates that there is no safe return available in the market and the only return available is the risky return which means that an investor looking for a particular target return would have to take excessive risk for extended period of time. This also means that for same target level of returns, now investor would have to accept more risks than the previous situation. Now given the high volatility of market returns in the periods of uncertainty, the long term and retail investors are prone to serious downside risks with. Faced with such a situation, investors/corporations/investors are left with two alternatives 1) Be indifferent between cash holdings and security holdings if their target return is low and can be compensated to some extent by lower yields of risk free assets and don’t go into risky ventures. 2) Take excessive risk to keep achieving the target returns consistently over time. There are certain headwinds to the strategy even if the investor chooses to take second option. Firstly, the diversification benefits reduce significantly since it is a well established fact the correlations amongst the markets and asset classes increase while great uncertainty prevails. Secondly, the involvement of central bank in the market, to certain extent, changes the fundamental asset price behavior. For example, if Fed continues to buy Mortgage Backed Securities during it QE, the price of security keeps going up and as a general rule may not revert to its long term mean as it would have in normal times. Thus typical strategies for investment focusing on shorting the overpriced and going long in underpriced securities may not be as successful as they would be in normal environment. This further adds to the probability of downside risks.
Even for corporate entities, same rule can be applied whereby equity investors target a certain level of returns. For example, consider a financial institution- say a bank- whose business model depends upon the movements in interest rate. In zero interest rate environments, the bank would have the liberty of paying low interest rate on deposits. But at the same time bank cannot charge a higher interest on its loans as well. Now if we personify bank as a retail investor with the loans portfolio the bank would also have two ways of earning spread (profit): 1) Invest in risk free securities to earn risk free return 2) invest in commercial loans to earn a risky returns. In a zero interest rate environment, the first source of spread dries up. The lesser interest rate paid on deposits also affects the bank’s ability to generate funds for its business since at no interest paid, the depositor would be at least indifferent between keeping money in hard cash (risk less) than lending it to a bank (who has certain amount of credit risk). However, the equity investors’ demand for a considerably higher return may push the bank for excessive risk taking just like a retail investor. This may have further serious economic implications since stable banks are essential for economic stability. The recent rise of banking scandals -JPM, Barclay’s and now HSBC- may be an indication that further the risk free spread remains unavailable, further the banks would be prone to the downside risks.
In short, while it is agreed that low interest rate environment is conducive for growth, but a prolonged zero interest rate environment may have its own implications for investors, markets and economy. It is necessary to regularly conduct a cost and benefit analysis of zero interest rate policy before extending it further.
(This work in an intellectual property of Author, I have no issues with the material being used given accompanied by a proper acknowledgment of source)