Maybe Higher Rates Are… A Good Thing

The specter of higher interest rates has been jumping out of closets and scaring stock markets for over a year. But go back a few decades and you’ll see that interest rates of 5% or more (blue line) were the norm. What’s more, stock prices did perfectly (fantastically in some cases) well during periods when rates were at or above that level.

The prevailing worry these days is that higher interest rates would make borrowing too punitive, slamming the brakes on consumer and business spending, and driving the economy into a nasty recession at some point.

It’s a reasonable concern, but when you look at this with that historical perspective in mind, you can start to see a different picture. The extended period of near-zero interest rates created problems of its own. Cheap loans encouraged too much borrowing, which pushed up asset prices (from houses to stocks) to unsustainable levels. By that logic then higher rates could even be a solution. Sure, they might cause some shaky, highly indebted firms to fail. And for anyone looking to get on the property ladder, they’re unwelcome. But a world – incentivized by higher rates – behaving a bit more cautiously when it comes to debt is unquestionably a good thing.

There’s some theoretical support for higher rates too. Students of neoclassical economics will tell you that saving = investment. The investment they refer to is fixed investment by firms (known as capital spending), not a financial investment in stocks or bonds. Now, the opposite of borrowing is saving, so it stands to reason that if higher interest rates mean people borrow less, then they should save more. And what do banks do with all that saving? They lend out to firms to invest in new factories, machines, and technology. And in theory, that should improve an economy's productivity, and therefore its growth prospects.

It’s true that firms (and people) can borrow without a build-up of savings. And if you’re thinking, it’s all about consumption, and more saving will mean less consumption, and that’ll be bad for firms and their profit. Well, you’d have a point, and there’s no getting away from it: the super-charged profit growth of the 2010s probably won’t be repeated any time soon. But it was too much borrowing that made us so vulnerable to rate hikes to begin with. So if you’ve got a long investment horizon, cheer up: a future whose foundations are built on more saving and less debt-fuelled excessive consumption is a more sustainable one. And as any longtime stock investor knows: a more sustainable future is a more valuable one.