Thursday, September 22, 2011

Why zero interest rate policies cause deleveraging

As I was traveling to Minneapolis today, I had a very interesting conversation -thanks Ted - about the Fed's various zero interest rate policies including quantitative easing and Operation Twist.

The key point that came out of the conversation is that interest rates below 2% provide an incentive for households and businesses to pay down their debt.

The incentive is that by paying off their debt they can earn a substantially higher risk-free rate of return than is available elsewhere. 

This is true for households even after refinancing at today's low interest rates.

As for companies, Ted said that his firm surveys CFOs and that interest rates at this level have essentially no impact on the decision to invest to expand as oppose to making the necessary capital investments to maintain existing capacity.

What zero  interest rate policies have effectively done in this financial crisis is changed the association of risk-free from applying to government securities to applying to the debt owed by individuals and companies.

This suggests that continuing low interest rate policies is in fact counter-productive.

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