Pumping the brakes

When the economy is overheated and asset prices are inflated, pulling the interest rate strings is the economic definition of “pumping the brakes”. Believe it or not, this financial lever works. However, pumping them too hard or too soft, can create significant problems. Braking is as much an art form, as it is a science.

It is obvious to see the impact of raising interest rates, but what if rates were kept low over the long term?

History is littered with examples of when central banks did not increase interest rates. Let’s take an alternate look into our global financial futures to see the long-term impact of low interest rates.

1. Asset bubbles and stock prices tend to plunge deeper for longer – When left unchecked, an asset bubble is when prices increase at an unsustainable rate. When markets realize that there is an overvaluation of an asset, the declines tend to be more severe. This can lead to a knock-on effect of higher long-term structural unemployment, increased bankruptcies, and corporate insolvencies.

    

2. Increased borrowing – You can spend a dollar or save a dollar. When rates are low, individuals, companies and countries can borrow more. The incentive to save is lowered as the historical interest rate you garner from savings accounts, bonds and other savings vehicles becomes less attractive.

    

3. Currency depreciation – Countries and governments invest just like you do. They search out the highest return for the least amount of risk. When rates are higher in other countries, this attracts short-term investments due to a higher rate of return. Keeping rates low makes the Canadian economy less attractive to foreign investment.

    

4. Inflation- Prices rise. Goods and services become less affordable. Inflation is not the only culprit in this equation, it is that incomes and wages do not rise in lock step with inflation.

When it comes to portfolios, it is important to remain hinged to the fact that equities have outperformed inflation significantly over time. A percentage of equity ownership within a retirement portfolio is a powerful tool to ensure that your capital keeps pace with inflation and the increase in taxes. In Canada, the TSX has outperformed inflation by roughly 5% per year over the last 50 years.

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