The Hidden Perils of Low Interest Rates

By: John Browne
Senior Market Strategist, Euro Pacific Capital, Inc. / Gold Seek

Late last year, with the U.S. economy experiencing falling unemployment and seemingly low inflation, observers were extremely confident that the Federal Reserve would move judiciously in 2015 to restore ‘normal’ interest rates sooner rather than later. However, in light of the recent fall in both stocks and oil, that conviction has softened considerably.

Many, such as the very influential Bill Gross, now believe that our current Zero Interest Rate Policy (ZIRP), which has been in place for six years, will remain in place throughout the year. While this likelihood is a disappointment to many, who would have preferred to see the economy move along without Fed-supplied training wheels, few really understand the pernicious effects these policies are inflicting on the economy the longer they are held in place. In short, ZIRP is slowly transforming the world economy into a dysfunctional basket case.

Historically, it has been estimated that a ‘normal’ fair rate of return on short to medium-term high quality debt is between 2 and 2.5 percent, net of inflation. Recently, the Fed published year-on-year U.S. CPI inflation for mid November 2014 at 1.3 percent. This would suggest normal short-term rates at around 3.5 percent at present.

However, using the government’s methodology that was in place prior to 1990, John Williams’ Shadow Government Statistics (SGS) newsletter calculates inflation to be currently some 5 percent. Using methods in place prior to 1980, it is a staggering 9 percent. At that level, current interest rates should be somewhere around 11.0%. Even if we estimate that real inflation is currently 3%, then our “normal” rate of interest should be around 5%. This is some 50 times the rate paid currently on most bank deposits. This gap is distorting the economy in untold ways. 

In early December 2014, the U.S. Congress approved further Government spending of some $1.1 trillion. This came just as the U.S. Treasury’s debt broke through a total of $18 trillion. It wasn’t that many months ago that the $17 trillion barrier was first breached.

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