Remember Alan Greenspan? Depending on the year your history book was printed, he was either one of the world's great central bankers, or the man who implemented an economic ideology that created the preconditions for the GFC. His reputation travelled a pretty fair distance in a few short years.
To be fair, it wasn't just Greenspan. Economic orthodoxy suggested the market knew best, that home ownership should be extended to almost everyone, despite their ability to afford it, and that low rates and less regulation were the answers to most, if not all, economic challenges.
Everyone, from left-leaning Presidents to right-leaning free-marketeers, was on the train. So it's churlish to apportion blame to one, or a few people — though someone needs to be accountable for the decisions made.
And because it's a truism that generals tend to fight the last war, we need to be careful not to fall into the same trap. But there are more than a few parallels when it comes to current monetary policy the world over.
The theory goes that low global inflation and low economic growth in most of the world justifies — nay, requires — low interest rates. That much isn't controversial. It is, dare I say it in the context of what I wrote above, the orthodoxy.
Interest rates should, generally speaking, be proportional to inflation — when the latter is high, raising rates should bring it down. And when it's low, dropping rates should improve things.
But what if rates are too low for too long? What behaviours does it tend to incentivise, if not directly cause? The answer is 'excessive risk taking', and yes, that should be ringing some bells. After all, if interest rates — the cost of borrowing — are higher, then you need a more certain payoff before taking out a loan. When they're lower, that hurdle falls. Once-questionable projects get the green light. And, yes, house-hunters can afford to pay more and more for housing, because the repayments are (temporarily, at least) low.
When rates go up? In the extremes, It's almost not worth thinking about. Now, the RBA (and its international counterparts) know that. So they'll be cautious when moving the lever to 'up', as we saw recently with Jerome Powell's US Federal Reserve decision to keep rates on hold.
Of course, it's a relatively no-win situation: push rates up, and you cause economic stress. Leave them low, and the fuel load continues to build, just waiting for a spark.
Investors need to keep this in mind too. Lower rates — or rates simply being kept low — are great for asset prices… in the short term. It lowers companies' interest bills. It lowers the 'discount rate' that professional investors use to value shares, meaning they'll pay higher prices.
The problem? As we've seen with house prices, once that tide is all the way in, it only has one way to go.
Foolish takeaway
Don't take from my warning that you shouldn't invest. Some properties will continue to increase in value, either because they're unreasonably cheap now, or because scarcity and growing demand should push up prices. Similarly, companies that can deliver growth, and from reasonable valuations, will continue to do well — perhaps very well.
And maybe we truly are in a new normal of permanently lower rates, and higher prices.
It's tempting to see rising prices as vindication of our own abilities, and to get caught up in the excitement. And, over time, share prices do tend to head north. But just be careful not to get too carried away; what the market and the RBA giveth, they can also taketh away.
