Many investors cheer the news that central banks are considering lowering their policy rates.  After all, low rates are aimed at encouraging investors to adopt more aggressive behavior and move into riskier, higher-yielding investments such as corporate debt and equities. We often hear about how low rates release the so-called “animal spirits” that drive business capital expenditures and stimulate growth. One so often hears a muted cheer on the floor of the stock exchange when the latest Fed announcement hints at rate cuts. Investors jump into the market, hoping to get ahead of the curve before an actual rate cut comes into being. We are experiencing this very reaction today, following the FMOC meeting yesterday and its clear signal that rate cuts are coming, possibly as soon as July. The bond market anticipated rate cuts as evidenced by a dramatic drop in the 10yr UST, nearly 60 bps since mid-April.

(Click on image to enlarge)

Source: WSJ

The brilliant economist, Milton Friedman, always argued that low-interest rates are a ‘bad’ thing. He drew upon economic history to show that a combination of economic weakness and very low inflation almost always leads to near-zero interest rates. Falling output leads to a sharp drop in business-credit demand for new investment, and low inflation or deflation reduces interest rates. In reference to the low rates instituted in Japan after that country’s financial crash in the early 1990s, Friedman argued low rates are a sign that money is tight, that banks do not want to lend and that the demand for funds is weak. More to the point, it is a fallacy to think that high rates are identified with tight money and low rates with easy money. Just the opposite is the case. In other words, low rates are not a good thing. So, how does his interpretation of interest rate conditions square with what is happening today? Let's look at what is driving rates lower and are then ask ourselves: are these developments “good “ things:

• Trade Wars are weakening international trade not just between the US and China, but throughout the world; no country comes out a trade war undamaged;
• Currency Wars follow trade wars; we are already seeing signs of this when Trump railed against the ECB that its monetary policies are weakening the Euro at the expense of the US dollar;
• Political disruption as Brexit is being played out in all its machinations leading to further uncertainty within both the UK and the EU; and,
• Lower inflation accompanied by lower economic growth is a feature of the advanced countries; inflationary expectations are been downgraded and stand at one of the lowest levels in a generation.

Now, the investing community would counter this argument by pointing out that lower rates will stimulate growth, re-ignite inflation and lead to a recovery. Hence, the problem is solved as rate cuts remove negatives that hold back growth. However, the list of issues contributing to low-interest rates goes well beyond what monetary policy can deal with. Trade and currency wars, for example, generate a race to the bottom, as each trading entity tries to outdo the other. It will take a lot more than cutting interest rates to return to better economic performance. Friedman would not look favorably upon our world.