As we all know, interest rates have been really low over the past few years... because the Federal Reserve wants to stimulate economic growth after our near-death experience in 2008. And I think it's fair to say that the Fed's stance of holding interest rates low has helped our economy slowly get back on its feet. Realistically, we still have a long way to go before our economy fully recovers but this low interest rate policy has significantly aided our economic recovery to date.
While the Fed has kept interest rates low and announced plans to keep them low for the next year at least, it has, within its ranks, folks such as Jeffrey Lacker of the Federal Reserve Bank of Richmond who believe that the Fed should now start raising interest rates to avoid risks from rising inflation. Skeptics argue that a sustained low interest rate environment will lead to excessive borrowing and cheap money which will increase money supply in our economic system and result in higher prices and inflation... and to put their arguments in context, it's sort of like what happened in the early 2000's housing market where credit was cheap, where lenders recklessly ignored the borrower's credit and folks outbid each other and caused a bubble in home prices. And they have a point because high inflation could curtail borrowing and slowdown the healing of our economic recovery.
Yet, I believe that inflation isn't an overly looming threat because, although interest rates are low, recent banking regulation changes require banks to have higher cash balances on hand, causing them to be a lot more careful about the loans they make.
On the upside, this low interest environment has resulted in borrowings by solid businesses who want to lock in almost free money that they can invest in capital-intensive projects. This could have the effect of boosting future profits and simultaneously strengthening their competitive positions.
Inflation is also less of a threat because US consumers realize that excessive borrowing has ultimately hurt them-from foreclosures to lost down payments, layoffs and high unemployment. Therefore less demand will keep a lid on reckless spending and contain inflationary pressures.
And this lid on inflation will likely stay in place until lenders and borrowers see very clear signs of domestic and global economic strength. When that happens, many will rush to borrow and invest which could cause inflationary pressure. The Fed could then start slowly raising rates to counter inflation and in the best case scenario, U.S. and global economies could smoothly ascend to cruising altitude.
I expect interest rate hikes to start no sooner than late 2013 at the earliest, and I expect that these hikes will be small and measured, where the Fed will also clearly communicate its near term plans on rate hikes so businesses are not caught by surprise and can plan their borrowings and capital spending -sustaining stable employment and profit growth.
We all know from our own past history with credit on items such as mortgage interest rates, this uber low interest rate environment cannot go on forever and rates likely will rise in the future.
So how does this impact you as an investor and an individual?
As an investor, look at businesses that are borrowing substantially at low interest rates and dig into what they plan to do with this money. My guess is they will have huge advantages with cheap capital for future expansion which will create a competitive edge causing higher future profits and perhaps delivering outsize share price returns. If you do this right and invest in such companies over the long run, your portfolio could see sizable future gains. Also know that rising interest rates will cause bond prices to fall so invest in bonds if you must but do not lock yourself into anything with maturity of over 5 years. Also be aware that a crisis in Europe or Russia or China could derail future economic growth which could lead to a flight of capital to the safety of US Treasuries so government bond funds could still do well.
As an individual, take advantage of low interest rates on necessary items such as appliances, buying a home while mortgage rates are low, borrowing for school and college and so on... and let me reiterate, focus on necessary purchases only.
So this low interest rate environment is ultimately good for you, for American businesses, for higher employment and our economy as a whole, but in time, rates will rise which is a important part of a healthy economic cycle.