Thursday, June 25, 2015

What happens when interest rates rise?

First off, I don't know the answer!

The problem lies with what economic theory predicts and what actually happens.  In a Keynesian system printing additional money will lead to one inexorable outcome:  inflation.  Granted we often think of inflation as the consumer price index -- which has gravitated around the 1-2% mark for the past 10 years.  We have unprecedented low interest rates -- inflation (CPI) is either slightly higher or equal to the interest rates.

On the other hand cars appear to be much much more expensive than they were 10 years ago (granted they all have bluetooth now...).  Computers seem to be cheaper (or at least the price of a MacBook air has not changed in 7 years -- its still around $1,200), but the box is better -- I guess!

So what is the long term impact of ultra low interest rates, of massive money printing?  Where is the hyper inflation, where is the social breakdown?  I don't see it.  I know that pension funds are finding things harder when they have a target return of 7.25% (In Canada is statutory for PV calculations), but when the Canadian government borrows at 2.5% for 10 years, its hard to see how they achieve their stated return target.  But the stock market and their real estate holdings have been doing well.

Granted a few markets have been on fire:  House prices (in almost the entire G7) are at historical high, stock market are considered "fairly priced" by insiders (that's typical double speak for -- wow that's expensive) so what we have seen is massive asset inflation. but relatively stable purchasing power for consumers.

What happens when interest rates start rising again?  Will the asset prices start falling (Bond prices will fall that's for sure -- its mathematical) but what about the market, real estate?

How will all this after pension funds, financial institutions, the "real economy"?  Just don't know, but after nearly 10 years of historically low interest rates one wonders.

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