This article was first published in the January 2017 international edition of Accounting and Business magazine.

When central bankers want to step on the economic accelerator, they often do so by cutting interest rates. Reducing borrowing costs has long been a reliable way to drive growth forward, encouraging consumers and businesses to borrow and spend. But after years of ultra-easy money, more economists are starting to wonder whether we have had too much of a good thing. 

‘There is a diminishing return to almost everything, and easy money is no exception,’ says Mark Calabria of the Cato Institute in Washington DC. ‘We may be approaching a point where central bank efforts to stimulate the economy have paradoxically become a brake on growth and not a fuel injection.’ 

This is potentially worrying, since ultra-low rates may well be here to stay for some time. ‘In many parts of the world, governments have been relying on central bankers alone to prop up economic growth,’ says Marc Chandler, chief currency strategist at Brown Brothers Harriman in New York. ‘Cheap borrowing has been the main way policymakers have sought to prevent nations lapsing back into recession since the 2008 financial crisis.’ 

And while the US Federal Reserve is expected to raise rates by a quarter of a percentage point in 2017, most economists forecast unusually low interest rates for years to come. The Bank of England is now thought likely to keep its rates close to zero for years to come as officials seek to prevent a relapse into recession. If financial markets are to be believed, the Bank of England’s base rate won’t rise back above 0.5% before 2021. The eurozone and Japan, economists believe, are also set for years more of unusually cheap borrowing. 

So how could low rates end up slowing economic growth? 

Taking its toll

‘Central bankers have become accustomed to looking at the world through the eyes of debtors,’ says Alex Pollock, the former chief executive of a Chicago-based regional bank. ‘Cheap money is a subsidy for debtors, but it is a tax on savers.’ Punishing savers for such a prolonged period may be starting to take a punitive toll, Pollock argues. 

For a start, low interest rates raise the cost of an annuity – the financial instruments that are needed to fund a comfortable old age for pensioners. Take a hypothetical example. At a real interest rate of 1.5%, it will cost US$870,000 to buy an annuity that will deliver an income of US$3,000 a month for a retiree with an anticipated life expectancy of another 30 years. But lower the real rate of interest to 0.5% and you need to find US$1m to generate the same level of income. To bridge the US$130,000 capital gap a 50-year-old worker would have to save roughly an extra US$700 a month over the 15 years remaining before retirement, according to research by UBS Bank. ‘This is exactly the opposite of what the central bank wants,’ says Calabria. ‘Rather than borrowing and spending more, people nearing retirement have a powerful incentive to hoard more as interest rates fall.’ As populations age in developed nations, this dynamic could become increasingly important. 

The same logic may also apply to those seeking to amass a ‘rainy day’ fund to protect themselves against economic misfortunes such as unemployment. In 1990 when a six-month certificate of deposit paid an 8% interest rate, it would take nine years for the magic of compounding to double the nominal value of your savings. Now, 25 years on, with a certificate of deposit offering around 0.16%, it would take approximately 430 years to double your money. 

‘If people have a target for how much they want to accumulate – such as the equivalent of six months of salary – they may decide to save more and spend less in a low-rate environment,’ says Pollock. ‘In addition, low interest rates can send a signal to citizens that the country is in a state of economic emergency, which can also encourage people to boost their precautionary savings.’ Recent experience provides some support for Pollock’s theory. Since September 2006 the Fed funds rate has come down from 5.25% to just 0.4%. Yet over the same period Americans have upped their savings from 3% of disposable income to 5.7%. 

Persistently low interest rates may end up having harmful unintended consequences for companies too, possibly lowering corporate investment. In theory, companies invest more when the cost of borrowing is lower, since a wider range of projects become potentially profitable. But low interest rates have recently proved a relatively poor way to encourage companies to boost capital spending. Despite ultra-cheap borrowing costs investment in fixed assets in the UK is now near its lowest level since the late 1950s as a share of national income. 

One possible explanation is that low rates give companies an incentive to pay larger dividends or buy back shares rather than investing in long-term projects. ‘Investors end up looking for bond-substitutes in the equity markets to provide the fixed income they are missing,’ Pollock explains. ‘If investors reward companies that return cash to shareholders, this effect may lower capital spending.’

Then there are the potential strains placed on the financial system when rates stay low for so long, says Calabria. ‘The assumption has often been that as rates go down there will be more demand for loans – from consumers and businesses,’ he explains. ‘But low or negative rates also squeeze bank profits.’ If the gap narrows between short-term interest rates and the longer-term loan rates, then banks make less money. ‘Instead of lending more, banks can actually feel less secure and so become less willing to lend,’ Calabria points out. ‘That can have a dampening effect on economic growth.’ 

The International Monetary Fund has recently sought to draw attention to a potentially more explosive problem – the difficulties faced by insurance and pension companies, which have fixed obligations to policyholders or retirees and are finding returns on their investments to pay them compromised by low interest rates. ‘The solvency of many life insurance companies and pension funds is threatened by a prolonged period of low interest rates,’ the IMF warned in its April 2016 global financial stability report. And as the IMF points out, insurance and pension funds are heavy-hitters in finance, holding about 12% of global financial assets, or US$24 trillion.

Risk of backfiring

Finally, there is the more familiar threat that unusually low rates – even if they spur growth in the short term – ultimately backfire by leading to overheating of assets, such as housing or stocks. As former Fed chairman William McChesney Martin said, the job of a central bank is to ‘take away the punch bowl just as the party gets going’. This risk has not gone away. Only in November, the current Fed chief Janet Yellen warned that ‘holding the federal funds rate at its current level for too long could also encourage excessive risk-taking and ultimately undermine financial stability’. 

The Fed finally looks poised to start tightening monetary policy, but US rates are still likely to remain far below historical averages for years to come. And near-zero rates can be expected to persist far longer in most other rich nations. ‘The longer this lasts, the greater the chances that damaging unintended consequences will materialise,’ says Calabria. ‘At a certain point, central banks may just have to admit that they have run out of effective ammunition.’ Central bankers appear unwilling to make any such admission – so far. 

Christopher Fitzgerald and Fernando Florez, journalists