Why the 0 lower bound means sensitivity to higher borrowing costs

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Sep. 25 2014, Updated 4:00 p.m. ET

Zero lower bound interest rates

Interest rates in the major developed economies—including the U.S. and the United Kingdom—have been artificially suppressed below 1% for nearly five years now. This suppression is due to the scale of central banks’ accommodative measures.

An accommodative monetary policy is designed to stimulate economic growth by lowering short-term interest rates. It makes money less expensive to borrow.

US top 10 capex 2013

Economies recovering from a recessionary phase need available credit at cheaper rates. With cheaper credit, spending and investments increase. This increase promotes capital formation and gross domestic product (or GDP) growth.

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According to a Progressive Policy Institute report, 25 companies invested an aggregate of $152 billion in new property, plants, and equipment in the U.S. in 2013. This includes a whopping $21 billion investment by telecom giant AT&T (T) and a massive $15.4 billion investment by Verizon Communications (VZ).

But interest rates remaining “too low for too long” could lead to credit and asset bubbles, as we discussed in Part 4 of this series.

Investment impact

Low interest rates do help revive the economy. This trend is evident in the revival of equity markets in a number of developed economies that have returned to all-time highs and the rising property prices in the U.S. and the United Kingdom. Major indices of the U.S. stock market, like the S&P 500 (SPY), Dow Jones (DIA), and NASDAQ (QQQ), are surging to record highs.

But a key risk that emerges from this trend is that asset markets and business investments tend to become overly reliant on low interest rates. In other words, they become sensitive to higher interest rates. In this kind of scenario, a rise in interest rates poses the risk of a sudden cutback in business investments and consumer spending.

Interest rates in the U.S. and the United Kingdom are expected to rise next year in a slow and calibrated manner. But the risk that higher borrowing costs could lead to a cutback in investment and spending still looms over these recession-stricken fragile economies.

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