Back in the dark days of 2008, with the very existence of the global financial system in grave danger, slashing interest rates and pumping liquidity into the global economy through whatever means available was entirely appropriate. Failure to support the banking system would have resulted in a far greater and more prolonged global recession and at a greater cost to governments and tax payers than that spent on bailouts.
However, why US interest rates remain near zero with the economy about 25 per cent larger now than during the depths of the summer of 2009 is harder to justify. In this period, unemployment has almost halved from 10 per cent to barely above 5 per cent, a level consistent with other growth periods when interest rates were substantially higher. Real wages have also been growing for a year now at levels where we have historically seen rate hikes.
Yes inflation remains low or even nearly negative, but this alone should not be reason to anchor the cost of money at zero for a seemingly endless period. Other countries, such as the UK, have also experienced similarly strong economic recoveries yet rates remain nailed to all-time lows despite this.
It seems that some powerful vested market interests have managed to convince central bankers that zero rates are the most desirable state for monetary policy. Observe the taper tantrums experienced in 2013 as the Fed threatened to begin the process of removing QE.
The one thing that low rates have incontrovertibly achieved is outsized financial returns on pretty much any asset class you can think of over the past six years. Unsurprisingly, those that have benefitted the most seem the most vocal over the dangers of ever leaving the comfort of zero rates, arguing that without inflation surely things should be left as is.
However, mispricing the cost of money also leads to the mispricing of everything else. If Japan has taught us anything it is that low rates promote the misallocation of capital. Inefficient businesses suck capital away from parts of the economy that would utilise it far more effectively, and excess capacity is never removed, dooming industries to ever lower margins, pricing and deflation. Throw in an ageing population and this is the cycle that 25 years on Japan still cannot shake off, despite rock bottom interest rates throughout the period.
Perhaps it is time that central banks took some responsibility and stepped away from the business of manipulating markets, priced money correctly and allowed market forces to more appropriately allocate capital.
Look no further than the commodity industry to see a situation that almost limitless and virtually free credit has created. A significant proportion of new debt raised over the past few years has been issued by oil and gas producers operating in the shale fields of the US. A huge glut of production, coupled with a slackening of demand, has resulted in the collapse in the oil price that we have seen over the past 12 months or so.
However, despite expectations that producers would be forced out, the fact their financing costs are so low means they are actually encouraged to produce more to generate the cash to meet interest payments in the short term. Also, when creditors are confronted with the choice of default or the extension of further credit, they will again be happier facilitating greater production rather than suffer complete loss. Hence producers keep producing and prices keep falling.
This is exactly the situation that Japan failed to deal with in the 1990s, to their great cost, as zombie businesses were kept alive by banks that could not afford for them to fail, at the expense of denying liquidity to businesses that actually could generate attractive returns. This is why operating margins in Japan in the 1990s remained so pitifully low, barely rising above zero.Perhaps a sign of things to come for Europe and the US if rates remain as low as to keep on encouraging this misallocation of capital.
Excesses can be observed across the commodity complex whether it be mining, oil and gas, or agriculture as a result of years of over-investment. The same is true of many heavy industries, a situation that inevitably leads to a loss of pricing power and falling margins and returns. Not so great for the markets after all.
However, raising rates will be hard and painful. To remove the excess capacity that is weighing on pricing globally, those companies that do not generate sufficient returns and are weighed down by excessive debt need to be removed. This will inevitably lead to rising unemployment and possibly recession, so should rightly be approached carefully. A gently rising interest rate environment should allow those who are strong enough to survive adapt sufficiently. But the economy will almost certainly slow, which is a situation that central bankers will find it hard to justify to the public and their politicians.
The benefits of returning to a normalised interest rate environment will hugely outweigh the short-term costs and allow global economic growth finally to rebound in a more meaningful way from the financial crisis. Allow market forces to allocate capital, not bureaucrats and central bankers, and the economy will be fine. If not then the current economic environment is probably the status quo for the next few decades.
Jake Robbins is senior investment manager on the Premier Global Alpha Growth Fund at Premier Asset Management.