“Too low for too long” poses a risk
Interest rates remaining “too low for too long” pose yet another risk to the world economy. Central banks keep interest rates low in order to boost consumption demand in a slowing or recovering economy. This often leads to increases in asset prices and increased consumer vulnerability to higher interest rates.
Persistently low interest rates in certain developed market economies—such as the U.S. and United Kingdom—have led to elevated asset prices and increased vulnerability for businesses and households to higher interest rates.
The vicious supply and demand relationship
Moreover, the availability of easy money tends to increase demand for asset purchases (like houses). This in turn leads to increases in asset prices, bolstered by increases in demand. Increased demand prompts lenders to increase the credit supply, even on relaxed terms. This then adds up to increased credit risk within the sector.
Increased credit risk doesn’t bode well for investments and the economy in general. It often leads towards a credit or asset bubble.
The U.S. housing bubble of 2008–2009 was a result of Americans with the poorest credit being lent money to purchase houses they couldn’t afford, as money was available for cheap. That trend affected the U.S. economy badly. Broad market ETFs such as the SPDR S&P 500 (SPY) and the Vanguard Total Stock Market ETF (VTI), real estate ETFs like the iShares U.S. Real Estate ETF (IYR), and banks like Citigroup Inc. (C) and Bank of America (BAC) all saw their prices slump.
While interest rates in the U.S. and United Kingdom are expected to rise next year in a slow and calibrated manner, the negative impact on credit quality, asset prices, and business investment could still be significant. The risk isn’t exclusive to the developed world. It could trigger further downward pressure on emerging market currencies and pose potential financial difficulties to households that would have increased their leverage significantly by then.