Thank God for zero interest rates

You heard me complain a lot about central banks and how their move towards zero interest rates has made monetary policy completely ineffective. But there are also some benefits of zero interest rates.

First of all – and probably most important – keeping interest rates extremely low for a long time reduces the discount rate with which investors calculate the present value of future cash flows. And this of course drives the valuations of stocks and other assets higher. The farther in the future the cash flows are, the more these assets benefit from lower interest rates and a reduction in discount rates. Thus, growth companies and private equity are likely to benefit more from lower interest rates than value stocks. If you think that investors don’t adjust their discount rates to the prevailing interest rate environment, then I suggest you look at the annual survey of Pablo Fernandez on risk premia and discount rates used by investors around the world. The risk-free rate used in Germany, Switzerland, and Japan is c. 0.8% to 0.9%, while the risk-free rate used in the United States is 1.9%. In the UK it is 1.1% in the latest survey, but it used to be 2% between 2015 and 2019. 

But lower interest rates imply not only an asset boom but also the potential for another housing market boom. And we know that excessive growth of house prices can end badly. The risk of a persistent low-interest rate environment is that banks will start to lend frivolously to homeowners and businesses. And a new study has shown that while rising lending activity alone is only mildly indicative of a future financial crisis, the combination of rising asset prices AND rising lending activity is highly indicative of a future crisis. 

The study looked at the growth of lending to businesses in combination with growth in the prices of stocks. They also looked at lending to homeowners in combination with the growth in house prices. For each variable, they declared a Red-zone (or R-zone) if growth over the previous three years is in the top 20% of the historical experience. If both lending activity and asset price growth are in the R-zone of a country, the risk of a financial crisis is 40% higher. The chart below shows the various financial crisis since the end of World War II and the credit and asset growth in the previous three years. 

Asset growth combined with credit growth predicts crises

Source: Greenwood et al. (2020).

The bad news is that I expect us to be heading into another period of rapid asset price growth after this crisis ends. The good news is, well, that central banks are likely to keep interest rates close to zero for a long time. And there is a series of papers (here and here) by the Bank for International Settlements that show that at zero interest rates, banks are increasingly unlikely to expand their lending activities even if there is a large demand for loans and mortgages. A broken lending channel may well be what keeps us from experiencing another financial crisis in a few years’ time.

Of course, the above model also provides a simple early warning system to detect a financial crisis. If lending growth and asset price growth both accelerate to high levels, we should justifiably become nervous.