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Roula Khalaf, Editor of the FT, selects her favourite stories in this weekly newsletter.
The writer is co-founder and co-chair of Oaktree Capital Management and author of ‘Mastering the Market Cycle: Getting the Odds on Your Side’
Most people want to see low interest rates. But low rates alter investor behaviour, distorting it in ways that can have serious consequences. As the excellent book The Price of Time: The Real Story of Interest by the financial historian Edward Chancellor makes clear, there are many negative aspects of so-called “easy money”.
Easy money keeps the economy aloft, at least temporarily. But low interest rates can make the economy grow too fast, bringing on higher inflation and increasing the probability that rates will have to be raised to fight it, discouraging further economic activity. This oscillation of interest rates can cause an economy to see-saw between inflation and recession. No one should want this.
Further, low rates reduce the prospective returns on safe investments to levels considered unpalatable, encouraging investors to accept increased risk in pursuit of greater return. Consequently, in low-return times, investments are made that shouldn’t be made; buildings are built that shouldn’t be built; and risks are borne that shouldn’t be borne. Capital moves out of low-return, safe assets and into riskier opportunities, resulting in strong demand for the latter and rising asset prices. This encourages further risk taking and speculation.
As the late Charlie Munger wrote to me in 2001, maybe we have a new version of the 19th-century British historian Lord Acton’s adage: “Easy money corrupts, and really easy money corrupts absolutely.” The investment process becomes all about flexibility and aggressiveness, rather than thorough diligence, high standards and appropriate risk aversion. Investors tend to underrate risk, underestimate future financing costs and increase their use of leverage. This typically results in investments that fail when tested in subsequent periods of stringency. In addition, low interest rates subsidise borrowers at the expense of savers and lenders. This can exacerbate wealth inequality.
When you consider all the reasons for not keeping rates permanently low, I think the economic merits favour setting rates low only as an emergency measure. When I attended graduate school at the University of Chicago, the leading intellectual light was the economist Milton Friedman, who argued strenuously that the free market is the best allocator of resources. In this same vein, I’m convinced that so-called natural interest rates lead to the best overall allocation of capital. Natural rates reflect supply and demand for money. I believe we haven’t had a free market in money since the late 1990s, when the Federal Reserve became “activist”, eager to head off problems real and imagined by injecting liquidity into the financial system.
So, are we likely to see the return of easy money conditions? At present, I believe the consensus is as follows: US inflation is moving in the right direction and will soon reach the Fed’s target of roughly 2 per cent. As a consequence, additional rate increases won’t be necessary. As a further consequence, we’ll have a soft landing marked by a minor recession or no recession at all. Thus, the Fed will be able to take rates back down.
To me, this smacks of “Goldilocks thinking”: the economy won’t be hot enough to raise inflation or cold enough to bring on an economic slowdown. Goldilocks thinking has historically tended to create high expectations among investors and thus room for potential disappointment. Of course, that doesn’t mean it’s necessarily wrong this time.
I believe we’re not going back to ultra-low rates for many reasons. The Fed may want to avoid remaining in a perpetually stimulative posture, given fears about kindling another bout of high inflation. Additionally, one of the Fed’s most important jobs is to stimulate the economy if it falls into recession, largely by cutting rates; it can’t do that effectively if rates are already near zero. On top of this, we appear to be seeing a decline in globalisation and an increase in the bargaining power of labour, suggesting that inflation may be higher in the near future than it was pre-2021. Thus, I’ll stick with my guess that rates will be around 2-4 per cent, not 0-2 per cent, over the next few years.
Of course, these beliefs are rooted in my thoughts on how the Fed should think about the issue. What the Fed will do may be different. But I believe it’s reasonable to assume that the investment environment in the coming years will be quite different from what we saw in the easy money era of 2009-21, meaning different strategies are needed by investors.
