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Interest Rates: Are Higher Rates Good Or Bad?

By Paul J. Carroll, CFP®October 19, 2023February 6th, 2024Videos

 

If you’re alive, if you’ve got a pulse, read the news, or looked at the credit card statement – you know that interest rates have come up. Long-term rates are up, short-term rates are up. This has caused all sorts of distress and it’s interesting. Why? These interest rates today historically are fantastic and I would argue that they’re healthy in the long run.

Why would I make the case that interest rates as they are today are a good thing?  Well, we really have to get down to fundamentals. I’m going to try to avoid too much theory here, but interest rates are the price of money. In the market economy, price signals are crucial to the allocation of scarce resources. In this case, the price signal is interest rate, and the scarce resource is money.

Now, prior to this hugely inflationary period, there was something running around the crackpot division of the left wing called Modern Monetary Theory, which essentially said you can just keep printing money with abandon and there’ll be no piper to pay.

You don’t hear a lot about that lately, and that’s because it was insane. It was insane when they said it, and it’s insane today. Money has a price, it’s an  interest rate, and it is dictated by the supply and demand. If you print money with wild abandoned, eventually you get what happens in Turkey, money depreciates and the only way to fix it, the only way to stabilize the currency is to get sky-high interest rates. That’s never been a good idea.

What’s been lost in all this conversation is that economics and finance are essentially not hard sciences, but behavioral sciences. As long as we are homo sapiens, humans making this decision, we’re impacted by incentives, by risks, and frankly by threats. Rising interest rates are painful. They cause losses in bond principle valuation. They cause loss in valuation period, because interest rates are always the denominator in the valuation formula.

So what’s so good about this? How quickly we forget the core problem of zombie companies that wouldn’t hurry up and die. Why is that good? Right now there’s plenty of news about these companies going out of business. It’s about time. Some of these businesses have been sucking up capital for as long as a decade. They’ve had no exit plan, they’ve had no way out, and they’ve been able to sustain it because the money was almost free.

So when Bed Bath and Beyond, just to make an example, stays in business, there’s no one else who can take that lot. No one else who can lease that space and no nimble young competitor that can work its way up the food chain with better products, better pricing, or better service. Zombie companies are toxic to the health of an economy. Unfortunately, and this is true everywhere in the world, zombie companies tend to have strong political constituencies protecting them, keeping them in business, and a fundamental part of that protection is free money.

It is good to see businesses that should have gone out of business, going out of business. Especially when we’re in an environment where there are more job openings than there are people looking for them. So it’s not as if the employees can’t find another job. Normalized interest rates eliminate unrealistic valuations and send better price signals to the market participants. It lets entrepreneurs know what risks they should be investing in, where they should be putting their efforts to add value, to create wealth, create jobs.

Normalized interest rates also normalize incentives. They tell executives and CEOs, hey, there’s a price to that stock buyback, and that price can be an opportunity cost of high interest that maybe they’re not willing to pay. It helps CEOs make smart decisions with the money, not only in the till, but the money they would consider borrowing too.

The fundamental economic concept that is not too hard to grasp for most normal people is there’s no such thing as free money. When market participants start believing there is, their behavior becomes abnormal. The pain we’re going through today somewhat is the normalization of appropriate sensitivity to the price of money. It really is a good thing. Just might hurt getting there.

We wish you the best of investing success.

Founder & CEO at Avion Wealth

Paul is the founder and CEO of Avion Wealth, LLC. He leads a team of wealth managers in building and executing financial plans for high net worth individuals and families. Contact Avion Wealth to speak with a financial advisor.