The Effect and Reason for a Reversal of a Low Interest Rate Environment

 "Let us say you borrowed $1 million at an interest rate of 10%, which was a good rate in the early 1980s. (See the above chart.) You would pay $100,000 in interest a year to keep that money outstanding.

Now, the rate of interest falls to 5%.  You could pay $50,000 in interest, or you could borrow another million and spend it, keeping the interest payment at $100,000.  What do you think both corporations, governments, and individuals did?  They borrowed the second million and spent it.

Now, the rate falls to 2.5%. You could once again pay $50,000 in interest, or you could borrow another two million.  Again, what do you think they did?  Yes, there is now four million outstanding that has been spent!

This continues until today, when one can borrow at close to 1%.  Instead of $1 million, you can now have $10 million outstanding with the same annual interest expense of $100,000.” (Market Ticker)

Effect of an interest rate reversal: What happens when the rate of interest goes to 2% from a mere 1%?  Answer: The interest payment required to keep the $10 million outstanding doubles to $200,000.  If you can't come up with it, then the only way to reduce it, other than bankruptcy, is to pay down $5 million of the $10 million you have outstanding. However, you don't have $5 million; you spent it.  That was, after all, the entire point of borrowing the money!

Oh, but you say the Fed can simply continue on with its ZIRP (Zero Interest Rate Policy) of the past 30 years. Well, no; because it would end up bankrupting all those private and public pension funds. You say what?  Pension funds normally use an investment assumption rate of 8%. That is, public and state entities negotiate with their employees over retirement benefits based on the assumption of earning 8%. However, when the investment return on those funds is less than 8%, like 2% in today’s investment environment, what the public entities have promised their retirees cannot be fulfilled. The promise was 8% to retirees but the fund earned 2%. The consequence is a major unfunded pension plan. Therefore, in order for these pension plans to fulfill their promises and survive, interest rates will have to rise.  And, that is the balancing act the Fed is trying to resolve.  Keep interest low enough to to keep the U.S. economy out of a recession but not low enough to bankrupt all those private and public pension plans. Well, good luck with that! (Financial Insights for the Eschaton)