Monday, January 11, 2010

Zero Interest Rates and Asset Bubbles

For homeowners, especially any lucky enough to be on a tracker mortgage, the current interest rate climate is an unspoken golden windfall.

Interest rates have never been this low in the UK, and the most likely prospect is for rates to remain close to zero for the considerable future.

There is no doubt that zero interest rates were the correct response to one of the most severe recessions and financial crisis of recent times. It is low interest rates that have helped avoid an even larger scale of home repossessions and have helped to prevent an even bigger fall in GDP.

Yet, whilst they are currently desirable, there is still a concern that the current interest rate climate could fuel another unsustainable boom in asset prices.

Interest rates are so low that investors are switching out of cash deposits and into assets such as shares and property.

It is this low interest rate climate that has helped witness a surge in share prices. The MSCI world index of global share prices is more than 70% higher than its low in March 2009. (source: Economist) It also helped to boost UK house prices, unexpectedly leading to a 9% rise in house prices in 2009.

Asset prices are still below historical highs. According to the Price / Earnings Ratio for the Dow Jones, US share prices are just above historical average of 17 (compared to a P/E ratio of over 40 at the start of 2000. (see: P/E at Greg Mankiw)

There may seem little sign of any boom in house prices at the moment. The recovery in UK high prices is hardly anything to get excited about, most commentators still expect them to fall this year. Yet, we shouldn't forget how easily we can forget...

Low Interest Rates and Deja Vu

One of the causes of the US mortgage fiasco was that exceptionally low interest rates were perceived to be normal and long lasting. To deal with the recession of 2001, the Fed aggressively cut interest rates to stave off recession. The low interest rates encouraged a raft of mortgage deals and rise in borrowing. It was ironic that efforts to deal with one financial crisis led to an even worse crisis a few years later.

We shouldn't forget such low interest rates are exceptional. When the economy returns to a normal path of economic growth, interest rates are likely to rise significantly. The problem with the naughties, is not so much that interest rates were cut in early 2000, but, the Fed was too slow to put up interest rates when there was a sign of a real recovery and boom in asset prices.

See: Taylor Rule and Interest rates

Also, of course, there was much more to the boom and bust than just interest rates.


1 comment:

online car loans said...

Correct me if I'm wrong but for some reason, after the housing bubble, interest rates on home mortgages dropped and those liquid enough were able to buy properties left and right so it was a good thing for the privileged, I suppose.