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Low interest rates can be inflationary, but high interest rates can kill banks. Here's how...

by Rachel MillsMarch 21, 2023
Wall Street Tight Rope

Would you like low inflation or a stable banking system? The way it's looking these days, you can't have both.

The Federal Reserve sets interest rate policy in this country. It is our central bank that centrally plans certain key aspects of our economy. Do they always get it right? Clearly not. They are supposed to set policies that keep prices stable and maintain employment at a certain level. Like a smoothly spinning top, the Fed keeps the economy humming along. Except now the top is spinning wildly out of control.

After the housing and banking crisis of 2008, the Fed cut interest rates to near zero, getting us through the crisis, but then they kept them there, building an inflationary bubble for the last 13 years or so.

Low interest rates can be inflationary in 3 main ways.

  1. Increased Borrowing and Spending: When interest rates are low, borrowing becomes cheaper, which can lead to an increase in spending by individuals and businesses. If the increase in spending outstrips the economy’s capacity to produce goods and services, it can lead to inflation.
  2. Asset Price Inflation: Low interest rates can make it cheaper for investors to borrow money to invest in assets such as stocks, real estate, or commodities. This can drive up the prices of these assets, leading to asset price inflation, which can spill over into other parts of the economy.
  3. Currency Depreciation: If a country’s interest rates are significantly lower than those of other countries, it can lead to a depreciation of its currency, as investors seek higher returns elsewhere. A weaker currency can lead to higher import prices, which can contribute to inflation.

Inflation has finally begun rearing its ugly head and the Fed has pivoted to higher interest rates to try to get the tiger back in the cage. What has this done? Jeopardized the banking system, as seen with the Silicon valley Bank collapse and the nearly 200 other banks at risk, including Credit Suisse. Here's what higher interest rates do to banks:

  1. Increase in Loan Defaults: When interest rates rise, it becomes more expensive for borrowers to borrow money. This can lead to an increase in loan defaults as some borrowers may struggle to keep up with their loan payments, especially those with variable-rate loans. If the banks have a significant portion of their loan portfolio in default, it can lead to a reduction in their income, which can result in financial difficulties.
  2. Decrease in Deposits: Higher interest rates may make it more attractive for customers to deposit their money in other investments that offer better returns than banks. This can lead to a decrease in deposits, which can cause liquidity problems for banks.
  3. Increase in Costs: When interest rates rise, banks’ borrowing costs also increase. This can lead to a decrease in the bank’s net interest margin, which is the difference between the interest it earns on its assets (such as loans) and the interest it pays on its liabilities (such as deposits). If the net interest margin becomes negative, it can lead to losses for the bank.
  4. Investment Losses: Banks often invest in securities that are sensitive to changes in interest rates. When interest rates rise, the value of these securities may fall, which can result in investment losses for the bank.

The Federal Reserve has put itself between a rock and a hard place with its interest rate policy decisions. Eventually the bubble they blow has to pop. Their response has been to blow more bubbles. If their financial roller coaster is not exactly the kind of excitement you enjoy, you may want to consider fortifying your portfolio with precious metals so you at least know you have something tangible to fall back on. Gold tends to move opposite the markets - in the long run. If you'd breathe a little easier owning gold and silver, give us a call.

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