Interest Rates Likely to Stay Low for Years – And Why That’s Important

The President of the Federal Reserve Bank of New York, William Dudley, gave a speech on Tuesday in which he gave three reasons why the short-term interest rate is likely to stay below its historical average for several years.  I’ll explain Mr. Dudley’s three reasons and why this matters, whether you are just starting your financial life, getting ready to retire, or somewhere between.

First off, why are interest rates going to stay low for several years?

  • The Economy Remains Weak.

Even though the jobless rate is (finally) coming down, the economy in the US remains very weak and dependent on “heroic” actions by the Fed – interest rates near zero and bonds purchases in the open market. Unfortunately this is likely to continue.

The largest driver of our economy is the housing market, but it is depressed as banks remain unlikely to loan mortgages to anyone with less than a stellar credit history, young people are slow to become first-time homeowners due to record-high student loan debt, and households were scarred by the Great Recession and are now much more conservative financially (good for their risk profile, but bad for economic growth).

  • Future Economic Potential is Lower.

The US economy is entering a period in which many citizens – the baby boomer generation – will ceasing adding productivity to the overall economy.  In other words, they will retire.  This means that the US economy will be much less likely to grow even when conditions improve.  The Fed will keep interest rates low in to compensate for the structural changes in the economy.

  • New Regulations have Changed the Economics of Banking.

Great Recession revealed how risky banks had become by taking on huge amounts of leverage to boost their profits.  New regulations keep that risk in check by requiring that banks retain a higher cushion of cash for emergencies – but the flip side of that coin is that banks are now much less profitable and they lend less.  Since lending stimulates the economy, these new banking regulations depress the economy.  The Fed will keep interest rates low to provide stimulation as an offset of the regulations’ effects.

So, if interest rates are likely to stay low for several years, how will that impact people?  Lower interest rates have impacts on everyone – and those impacts grow over time.

  • The Young, Just Starting Out.

If you are just starting out in your economic life, low interest rates give you the opportunity to pay off your student loans more quickly than you would be able to do with higher interest rates.  It would behoove you to do so as quickly as possible.  Once student loans are paid, you then have the opportunity of a lifetime – to get a home mortgage at an incredibly low interest rate.  One other item for the young – the only interest rate that has NOT dropped is credit card interest, which is still in the upper teens and even over twenty percent.  Avoid credit card debt in any way you can!

  • At or Near Retirement.

If you are retired or nearing retirement, low interest rates mean that you cannot depend on the low-risk steady stream of income that come from bonds – long the staple of investments for retirement.  Instead, you will need to look at preferred stocks that produce coupon dividends or common stocks that pay dividends.  As an example, my wife and I are now both retired, and we recently shifted assets into common stocks that pay dividends so we get a steady stream of cash and can participate in stock appreciation.

  • Between Starting and Retiring.

If you are between starting out and retirement, you have opportunities to structure your spending and investing to take advantage of these historically low interest rates.  On the spending side – be sure that you don’t throw away any money on credit card interest.  Be sure you pay off your credit cards every month, and look for a credit card that pays you cash back – generally 1% to 1.5% of whatever you spend.  Now is a great time to pay off any high interest rate loans and replace them with lower rate loans.

On the investment side, any interest that you earn will be low due to the low interest rates, so only keep cash in a savings account at a level you need for emergencies.  Put the rest to work in investments that will work for you.  For the next several years, you should look for investments that will increase in value and not investments that will pay interest (stocks rather than bonds).  Since stocks are inherently more risky than bonds, it makes sense to increase your diversification to compensate for the additional risk.

If you are running a business, low interest rates mean that loan financing is an option where it might not have been in the past.  Several companies that I have seen in the last couple of years have been able to finance themselves (at least partially) with loans rather than selling controlling interests to a venture capital investor.

When I was growing up, and even when I was getting my MBA, people regularly talked about “the magic of compound interest.”  Well, compounding interest was a lot more magical back then, when money-market rates were 20%, than today, with money market rates below 1%.

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One response to “Interest Rates Likely to Stay Low for Years – And Why That’s Important”

  1. John Burnette says :

    In a world that makes sense, the interest rate follows inflation. In inflationary times you get “money market rates of 20%” but you weren’t actually earning value, just “money”. But even those crazy “whip inflation now” days of Gerald Ford look positively sane in comparison with nearly free interest rates together with stealth inflation rates estimated above 5%.

    Mankind has been struggling with the very concept of money for as long as there’s been civilization. A couple of thousand years ago Aristotle defined the characteristics of good money as follows:

    1.) It must be durable. Money must stand the test of time and the elements. It must not fade, corrode, or change through time.

    2.) It must be portable. Money hold a high amount of ‘worth’ relative to its weight and size.

    3.) It must be divisible. Money should be relatively easy to separate and re-combine without affecting its fundamental characteristics.

    4.) It must have intrinsic value. This value of money should be independent of any other object and contained in the money itself.

    It’s fun to go through these one at a time.

    1) The Federal Reserve issued USD fails miserably on this one. As a store of value, the USD sucks – though all fiat currencies face the same issues.

    2) Money has become unbelievably portable, in fact, many problems we face these days is that money is TOO portable. Most money these days exist only in computers and thus actually has no weight or size.

    3) Likewise, not a problem.

    4) This is the one I find most interesting. Fiat money is SUPPOSED to be generated only when debt is incurred by someone. Thus there is supposed to be a built in demand (I must have a steady supply of USD to pay my mortgage to stay in my house) that then creates the intrinsic value for the little green pieces of paper. But when instead money is created to fund deficits – and mostly only to service the interest on current obligations – we’ve set in motion the very thing which will almost certainly destroy the USD’s reputation as having intrinsic value.

    Well enough ranting. Most teachers I know don’t really have to worry about where they have to store their big ol’ pile of money…

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