Ultra-low interest rates encourage bad investing habits, warns Howard Marks
In a recent memo, Howard Marks, founder of Oaktree Capital, cautioned against the negative consequences of ultra-low interest rates. Marks argued that, instead of being a tailwind for investors, these low rates incentivize bad investment behavior and discourage economic activity. He posited that the “natural” interest rate, which is determined by the supply and demand for money without the input of central banks, is the optimal rate for capital allocation. However, this natural rate has not been allowed to prevail in decades.
The dangers of low interest rates on economic activity, according to Howard Marks
Marks emphasized that a return to the near-zero interest rates that characterized the period between the Great Financial Crisis and the pandemic could lead to damaging investment behavior. While lower borrowing costs can stimulate the economy, rapid growth can result in inflation, prompting tighter monetary policy. This cycle of swings can dampen economic activity. Additionally, low rates can create financial mismatches, where long-term investments made under low rates become discounted when policy tightens.
The need for “natural” interest rates for optimal capital allocation
According to Marks, the current environment lacks a free market in money. He believes that since the late 1990s, the Federal Reserve has become activist, injecting liquidity to preempt or address real and perceived problems. Consequently, investors have become preoccupied with central bank actions and their consequences. Marks argues that the natural interest rate, determined by market forces, would be better suited for capital allocation rather than the interventionist approach of central banks.
How a return to low interest rates could lead to damaging investment behavior
Marks expressed skepticism about the possibility of a return to near-zero interest rates despite investors’ hopes for such a scenario. He highlighted the problems that arose during the pre-COVID era of easy money. Low rates tend to increase asset prices, as risk-averse investors shift their focus towards riskier assets like stocks, real estate, and private equity. This can create an environment of speculation and potential asset bubbles. Moreover, low rates penalize savers who do not invest in the stock market, contributing to wealth inequality.
The negative consequences of ultra-low interest rates on investing and economic activity
Ultra-low interest rates encourage bad investments by eliminating opportunity costs and promoting greater reliance on leverage. Even financially weaker individuals can borrow to finance investments that may be unsustainable under tighter monetary conditions. Marks quotes investor Charlie Munger, stating that “easy money corrupts, and really easy money corrupts absolutely.” Additionally, low rates discourage economic activity, create financial mismatches, and exacerbate wealth inequality.
Marks concludes that the recent lessons learned from the negative consequences of low interest rates may prevent a return to ultra-low rates in the coming years. Disinflationary factors, such as retreating globalization and rising labor bargaining power, may no longer be as strong. As a result, the Federal Reserve might maintain interest rates at levels sufficient to prevent future inflation. Marks suggests that the Fed funds rate could average 3.0%-3.5% over the next decade, although he acknowledges that this is merely a guess.
Analyst comment
Neutral news. The article provides a balanced view of the potential negative consequences of ultra-low interest rates on investing and economic activity. It suggests that a return to near-zero rates could lead to damaging investment behavior and create financial mismatches. However, it also acknowledges that recent lessons learned may prevent a return to ultra-low rates in the future. As an analyst, it is expected that the market may continue to experience some volatility as central banks navigate interest rate decisions and potential economic impacts.
