Central banks around the world are whacking interest rates at a breakneck clip. The Fed, the Reserve Bank of Australia, the Bank of Japan and now the ECB and the BoE. The BoE made the most dramatic move with an outsized 150 basis point cut. However, I am not convinced this is what the market needs.
Why are central banks cutting interest rates?
The conventional wisdom is that cutting interest rates provides monetary stimulus. Cutting interest rates will help prop up the economy at a time when commodity prices are plummeting, making inflation less of a concern. I do believe this is true and some easing might be just what we need at this delicate point. However, I also believe cutting rates has unintended consequences — and one of them is increasing the appetite for risk.
Before I go into why this is so, let me explain how I see interest rates with a blurb from a previous post.
The purpose of interest rates
Consider money to be just like any other good. Therefore, a loan is essentially an exchange of a 'present good' (money that can be used today) for a 'future good' (an IOU -money that can be used later). Because people will always prefer having a good straight away than receiving that good later, the present good commands a premium in the marketplace. That premium is the rate of interest.
Interest rates, therefore, represent thetime value of money. It is the mechanism through which individuals express 'time-preferences' i.e., how much more they value receiving money right now as opposed to a later date. The premium of present money over future money fluctuates according to people's time preferences; if people want money today very badly, the premium for money today (interest rate) will be high.
However, at some point, when the credit cycle has progressed too far, one of two things occurs:
- The economy 'overheats' and inflation starts to rise. Whispers start circulating that the central bank will raise interest rates and that inflation is spiraling out of control. The central bank does increase interest rates and many loans that looked good in a lower interest rate environment start to go sour.
- Banks simply start lending to too many questionable debtors and more loans go bad than anticipated.
Another example of this right now comes in the form of levered ETFs. These are exchange traded funds that allow investors speculators the opportunity to double or triple the gains from investing in the stock market. SeePaul Kedrosky's take on this here.
And when politics drives economic and monetary policy, bad things happen.