Interest rates are at the heart of current global debate. Will they go up, will they go down and what does this mean for everyone watching events unfold?
Since the financial crisis of 2008 interest rates have been slashed consistently by governments across the globe. Principally some Scandinavian countries have now adopted negative interest rates and the Bank of England have hinted that their already low interest rates could go negative. America continues with rounds of quantitative easing.
Over the years people have come to expect highs and lows in interest rates. These are appreciably cyclical and the odd recession will occur. The 2008 recession was unprecedented in that it was global and, according to many accounts, is still not over. The 2008 crisis has changed the outlook for interest rates and financial markets in general in ways which are still not fully appreciated.
Current interest rates are as president Obama described them “getting as low as they can go”. Lowering interest rates is the traditional weapon of choice for governments when faced with recession however in the current climate this has not solved the problem. Federal Reserve Chairman Janet Yellen has hinted numerous times at a rise in fed interest rates but this has not yet materialized. It is unlikely that she will raise rates and even if this occurs the rise will be extremely minimal.
The reason rates are being kept so low is not purely about dealing with recession. The real truth now is that so much debt exists in the world’s financial system that raising rates would potentially be disastrous. This concerns not only government and private sector debt but households also.
Of course anyone who depends upon high interest rates has been hit extremely hard by these developments, principally savers and retirees. The people who find this development very helpful are those with large debts such as mortgages. In the 2008 recession many borrowers defaulted on their mortgages because after a teaser rate expired they could no longer afford the monthly payments. This resulted in waves of foreclosures and the associated damage to individuals and hence the economy. In theory the low interest rates should keep as many people in their homes and paying on their mortgages as possible however it turns out not to be quite that simple.
Home equity lines of credit (HELOC) or second mortgages enabled homeowners to turn their property into an ATM, some properties providing more income than a stable job. However a large proportion of the people who took out these loans have paid only the interest and soon this wave of mortgages will require payments to be made on the principal also. Many people have already spoken out about how they expect to default and lose their homes when these payments fall due.
Another exacerbating factor in the new expected wave of the mortgage crisis is HAMP, the American government’s Home Affordable Modification Program which provided temporary interest rate relief to borrowers. From 2015 these relief rates are starting to run out and the rate paid by the borrower will rise gradually year by year. This program was intended to tide people over until the economy rallied however without a strong recovery in sight this iceberg is still in the water. Mortgage rates today are comparatively high, putting off many first time buyers. Essentially it is people already in properties who are being bailed out by the current interest rates.
The affordability of mortgages is a large component of the housing or real estate bubble. With real estate being such a big part of the economy measures have been put in place, both in the United States and other countries such as Great Britain, to re-inflate the bubble. While these efforts persist interest rates are likely to remain at or close to zero.
Of course this real estate bubble concerns investors and not just homeowners. Investors have had many years of easily selling on properties but there are fears that this bubble could burst much like the situation with Credit Default Swaps which heralded the start of the 2008 recession. The problem occurs when confidence is destroyed by doubt arising over the true value of an asset. A famous example of this is the Dutch Tulip Bubble of 1637. When an exorbitantly priced tulip failed to sell at auction the confidence which inflated the bubble burst and the value of the bulbs tumble2d.
Some researchers have driven through newly developed areas of offices or homes and report no lighting being on after darkness. Some people think that the amount of unsold homes and other properties could be the start of a deep crisis in the real estate market. If investors cannot sell these properties to customers or each other at the prices they expect the artificially enhanced property bubble is sure to burst.
Since no one wants the bubble to burst policies such as very low interest rates are persisting. Many people have placed a very heavy bet on the idea that house prices will continue to rise.
Aside from mortgages is the spectre of household debt. Since 2008 low interest rats have been used to encourage households to keep spending. The result is that households now carry more debt than ever before. If interest rates were to suddenly rise the effects on millions of people would be devastating. Not only would people struggle to pay off the debts they have they would be put off from taking on more. This is interest rates affect on the economy. The higher the rate the more cautious people will be. If debt is cheap and savings almost worthless people are being compelled to spend. In times when interest rates are high people avoid debt and save more.
As long as interest rates are low the economy can keep limping along, the hope is that later down the line something will change. For now this precarious balancing act is the status quo.
What will interest rates be in the future?
A fed interest rate increase is extremely unlikely to occur in the near future. Rates must rise eventually but it would be foolhardy to rely on a fed interest rate increase anytime soon.
In order for rates to rise the economy would have to reflect genuine job growth. This means people in well paid full time work as opposed to low hours contracts etc. It would also mean that a majority of all the people who took on too much debt in order to play the housing market are helped through the worst of their troubles.