Question

On Thursday the Bank of Montreal (BMO) announced that it was reducing the annual interest rate on their 5-year fixed-rate mortgage to 2.99%, the lowest in the bank’s history. Shortly after the BMO’s announcement, TD-Canada Trust issued a news-release to inform the markets that they, too, would be offering that low interest rate, followed shortly after with the same offer coming from the Royal Bank (RBC), Scotiabank and the CIBC.

Those low interest rates were being offered at a time when many financial experts, including the governor of the Bank of Canada, and the federal Minister of Finance had been warning all Canadians about the dangers of borrowing money, especially money that is being offered at very low interest rates.

Here we are, again, a bit more than one year later, and history is repeating itself, with the BMO and Manulife Insurance offering the cheapest rates on the street. This is not surprising, because March is usually the beginning of the “spring home-buying season” when people begin to look at buying either their first home or are considering “trading up” to a better home.

Questions

1)Few people who would argue against being able to obtain mortgage financing at such a low rate of interest as that being offered by the banks mentioned above.

Discuss the advantages of being able to receive this low interest rate if you were a person planning on buying a home soon, and needed to have a mortgage in order to buy that home. The obvious advantage is that your mortgage will cost you less if the interest rate is lower. We are looking for more than just that, so think “big picture”.

Answer 1

Benefits of Low-Interest Rates

In a market economy, resources tend to flow to activities that provide the greatest returns for the risks the lender bears. Interest rates (adjusted for expected inflation and other risks) serve as market signals of these rates of return. Although returns will differ across industries, the economy also has a natural rate of interest that depends on factors such as the nation’s saving and investment rates. When economic activity weakens, monetary policymakers can push the interest rate target (adjusted for inflation) temporarily below the economy’s natural rate, which lowers the real cost of borrowing. To most economists, the primary benefit of low-interest rates is their stimulative effect on economic activity. By reducing interest rates, the Fed can help spur business spending on capital goods—which also helps the economy’s long-term performance—and can help spur household expenditures on homes or consumer durables like automobiles. For example, home sales are generally higher when mortgage rates are 5 per cent than when they are 10 per cent.

A second benefit of low-interest rates is improving bank balance sheets and banks’ capacity to lend. During the financial crisis, many banks, particularly some of the largest banks, were found to have too little capital, which limited their ability to make loans during the initial stages of the recovery.

By keeping short-term interest rates low, the Fed helps recapitalize the banking system by helping to raise the industry’s net interest margin (NIM), which boosts its retained earnings and, thus, it's capital. Between the fourth quarter of 2008, when the FOMC reduced its federal funds' target rate to virtually zero, and the first quarter of 2010, the NIM increased by 21 per cent, its highest level in more than seven years. Yet, the amount of commercial and industrial loans on bank balance sheets declined by nearly 25 per cent from its peak in October 2008 to June 2010. This suggests that perhaps other factors were working to restrain bank lending.

A third benefit of low-interest rates is that they can raise asset prices. When the Fed increases the money supply, the public finds itself with more money balances than it wants to hold. In response, people use these excess balances to increase their purchases of goods and services and of assets like houses or corporate equities. Increased demand for these assets, all else equal, raises their price.

The lowering of interest rates to raise asset prices can be a double-edged sword. On the one hand, higher asset prices increase the wealth of households (which can boost spending) and lower the cost of financing capital purchases for business. On the other hand, low-interest rates encourage borrowing and higher debt levels.

Costs of Low-Interest Rates

Just as there are benefits, there are costs associated with keeping interest rates below the natural level for an extended period. Some argue that the extended period of low-interest rates (below the natural rate) from June 2003 to June 2004 was a key contributor to the housing boom and the marked increase in household debt relative to after-tax incomes. Without a strong commitment to control inflation over the long run, the risk of higher inflation is one potential cost of the Fed’s keeping the real federal funds rate below the economy’s natural interest rate. For example, some point to the 1970s, when the Fed did not raise interest rates fast enough or high enough to prevent what became known as the Great Inflation.

Other costs are associated with very low-interest rates. First, low-interest rates provide a powerful incentive to spend rather than save. In the short term, this may not matter much, but over a longer period, low-interest rates penalize savers and those who rely heavily on interest income. Since peaking at $1.33 trillion in the third quarter of 2008, personal interest income has declined by $128 billion, or 9.6 per cent.

A second cost of very low-interest rates flows from the first. In a world of very low real returns, individuals and investors begin to seek higher-yielding assets. Since the FOMC moved to a near-zero federal funds target rate, yields on 10-year Treasury securities have fallen, on the net, to less than 3 per cent, while money market rates have fallen below 1 per cent. Of course, existing bondholders have seen significant capital appreciation over this period. However, those desiring higher nominal rates might instead be tempted to seek more speculative, higher-yielding investments.

In 2003-04, many investors, facing similar choices, chose to invest heavily in subprime mortgage-backed securities since they were perceived at the time to offer relatively high risk-adjusted returns. When economic resources finance more-speculative activities, the risk of a financial crisis increases - particularly if excess amounts of leverage are used in the process. In this vein, some economists believe that banks and other financial institutions tend to take greater risks when rates are maintained at very low levels for a lengthy period. Economists have identified a few other costs associated with very low-interest rates. First, if short-term interest rates are low relative to long-term rates, banks and other financial institutions may over-invest in long-term assets, such as Treasury securities. If interest rates rise unexpectedly, the value of those assets will fall (bond prices and yields move in opposite directions), exposing banks to substantial losses.

Second, low short-term interest rates reduce the profitability of money market funds, which are key providers of short-term credit for many large firms. (An example is the commercial paper market.) From early January 2009 to early August 2010, total assets of money market mutual funds declined from a little more than $3.9 trillion to about $2.8 trillion.

Finally, This might occur in the event of a shock that pushes inflation down to extremely low levels - maybe below zero. With the Fed unable to lower rates below zero, actual and expected deflation might persist, which, all else equal would increase the real cost of servicing debt (that is, incomes fall relative to debt)