So previously we discussed what are interest rates, and today I want to talk about interest rates effect on investment. We will discuss this in two scenarios, how free market interest rates effect investment and how artificially low and high interest rates effect investment.
Free Market Interest Rates:
If banks and businesses are in a dire need of capital, interest rates will rise in order to generate the supply of capital. Individuals who have produced value via their labor will have capital which they can choose to save or consume, but the high interest rates indicate that if they postpone consuming today they’ll be able to consume even more tomorrow, enough for them to delay consumption. To take best advantage of these higher rates they may buy longer maturity investments, this ensures that the capital has been put to the side for a long time. Now that banks have plenty of capital put aside, the supply/demand relationship changes.
The supply of available capital is now bigger, so now the issue is to create demand for that capital which can be done by lowering the interest rate. Since this money has been saved generally long term by investors locking in larger rates of return, businesses can now borrow this money to borrow for long term projects which we’ll discuss more when we discuss interest rates effect on consumption.
This relationship allows capital stock to naturally replenish as it’s needed by letting the price mechanism work naturally.
Artificial Interest Rates:
In the current global system of interest rates, the rates in the market are manipulated by central banks, primarily by the Federal Reserve since they manage the reserve currency of the world, the U.S. Dollar. By flooding the markets with liquidity in order to generate demand for US treasuries (US debt), interest rates on these treasuries are pushed down, and the rate treasuries are at is called the Risk Free Rate of Return. Since no government has the same power to use fiscal and monetary policy to refinance it’s debt, the U.S. was considered the most risk free borrower on the planet up till recently. Since this was the orthodox logic, then all other rates pivoted off similar maturity treasuries. So if treasury rates went up, everything else went up and vice verse.
The problem is that injecting liquidity by the Federal Reserve increases inflation and makes it easier for the government to run larger deficits, meaning more taxation. This also means that investors, to make up for the extra inflation and taxation, will have to take on more risk, and the among to do so has increased since the risk free rate of return is lower, for example:
Tax Bracket: 35%
CPI (inflation): 3%
Risk Free Rate of Return: 3%
In this scenario I can just match inflation by investing risk free into treasuries, so for me to beat inflation I’d have to take on extra risk elsewhere and this doesn’t consider taxation. After taxation if only buying treasuries at the risk free rate of return my actual return would be 1.95% so I have a Real Return(inflation adjusted) of – 1.05 % so in order for me to break even I need a gross yield of 4.615%. Meaning, I need to find at least 1.615% of risk to break even. So I’m taking more risk and not even getting a return yet.
As Government spends more and more and increases it’s deficits, then this gap widens as the risk free rate continues to be pushed down as liquidity is injected to finance it by the federal reserve. This type of policy and intervention in interest rates puts pressure on investors to take on more risky and riskier investments which can lead to large losses by portfolio managers trying to keep up which typically are at the help of funds made up of mainly pension money and other retirement money.
Conclusion
If Interest rates like any other price are allowed freely to move up and down it will coordinate resources appropriately over time, although if government get involved as shown above it’ll cause investors and investment professionals to take on more risk just to preserve purchasing power and pay taxes, and as we saw recently results don’t go so well when you take on too much risk with people retirement money.
(No Ratings Yet)
(3 votes, average: 4.33 out of 5, rated)
