Wednesday, October 07, 2009

Challenging the Low Interest Rate Religion

In The Unintended Effects of Bad Policy (May 18th), I wrote that:

[L]ow interest rates often have the opposite of their intended effect. Extremely low interest rates can vacuum liquidity out of nations. Japan has been referred to as a nation where loose monetary policy was like “pushing on a string.” There was no push. It was a pull. Liquidity was sucked out of the country as the Yen became the world’s carry trade currency of choice. Borrowing in a currency is the opposite of investment. It is liquidity-draining to the carry trade currency nation. For all of the talk about using monetary policy to dampen the business cycle, no result could be more damaging or procyclical.

The test of such a statement would be a country which is raising interest rates, while the rest of the world keeps them low. This week, Australia has provided us with such a test. Their central bank has raised interest rates, and so far, Australian equity markets have moved higher

I would argue that their central bank’s decision to raise rates will incentivize capital to move from countries with anemic interest rates to Australia, which will (everything else being equal) benefit their economy and equity markets. Currently, central banks around the world operate under the erroneous assumption that anemic interest rates are stimulative. I have argued that ultra low interest rates increase asset prices rather than stimulate the real economy. Australia should benefit from its rate increase. Of course, only time will prove the point.

Hopefully, the world’s central bankers and economists are taking note.

Disclosure: Long EFA. Positions may change at any time.