Schafer: Low interest rates have us in uncharted territory

The financial writer Jim Grant, founder and editor of Grant's Interest Rate Observer, remarked in a Minneapolis speech this week that "it seems my business model needs freshening."

Now that governments or even car companies can borrow lots of money from investors at effectively zero rates of interest, he said, there are really no more interest rates left to observe.

That's the kind of dry remark typical of Grant, a contrarian and market historian likely all but unknown outside of financial circles.

What he had to say here, though, would have interested pretty much anyone trying to make his or her way in the world. That's because we have central bankers to thank for our zero-interest-rate environment, not the economy or the market for capital.

Just how much these well-intended central bankers have distorted asset prices — from what workers have stashed in stock mutual funds and hope to live on someday to the home they just refinanced — can't yet be reckoned.

But Grant called interest rates "the traffic signals of a market economy." And does anyone think it's perfectly safe to have all the traffic signals turn green at the same time?

As Grant stood at the podium Thursday night, he was well aware that he was addressing about 500 people from the Minnesota financial community at this CFA Society Minnesota annual dinner.

"The hint is do not forget the rule of 72," he said, referring to the old rule of thumb about how long it takes to double your money. "So the answer, of course, is about 72 years. But because I am among CFAs I will give you an exact answer, and the exact answer is it takes 68.97 years for your principal to be cut in half."

As extraordinary as a negative interest rate is, Grant explained there have times of really low interest rates before, though usually during tough economic times.

Interest rates in this country have been drifting down for more than 30 years. In the spring of 1984, the longest maturity U.S. Treasury bonds yielded about 14 percent. Those with a sense of U.S. economic history will remember that as a time of rampant price inflation. Of course interest rates had to be high, to more than make up for the loss of purchasing power in the dollar as prices of things people bought kept rising.

But as Grant pointed out, the inflation rate by that time had already come down to about 5 percent. That meant that the real, inflation-adjusted rate of return by investing in the safest bond in the world was about 9 percent. That's a level of return an investor might ordinarily expect only by investing in stocks, which carry a whole lot more risk.

The point of his story is at that time, no one in the financial markets was insisting that clients sell everything they owned and mortgage their homes to invest in the 9 percent, risk-free and inflation-adjusted rate of return then available in the U.S. Treasury bond.

Well, 0.2 does beat zero.

For Grant, this is an artificially low rate, the result of years of relentless monetary expansion by the Fed. And to him, an interest rate is just another price, typically "discovered" in the market. If the state of Minnesota brings a bond issue at 4 percent and it doesn't really sell, the interest rate ticks up until it does, and thus the price for Minnesota bonds is discovered.

But what happens when a central bank like our Federal Reserve decides, like it did after the Great Recession, that an interest rate needs to be zero? How, Grant asked, is that different from government price controls?

Our Federal Reserve has finally ended its extraordinary program of buying bonds to stimulate the economy by injecting money into the financial system, and it's all but impossible to exaggerate just how extraordinary it was.

The traditional way a central bank like the Federal Reserve combats a sagging economy really didn't get the economy moving, so the Fed moved on to the program known as quantitative easing. It was not necessarily a new idea, but nothing on the massive scale of what the Fed did had ever been tried. By the time it was done just a few months ago, the Fed expanded its balance sheet about $3.5 trillion through the purchase of bonds and mortgage-backed securities.

Grant told the story of German carmaker BMW this month issuing a five-year bond and 10-year bond, totaling €1.5 billion. The five-year bond had an interest rate of one-half of 1 percent, and the 10-year bond paid 1 percent.

Now of course, BMW is a great company. It's nicely profitable, and stockholders get a dividend that returns well above 1 percent.

So why, Grant wanted to know, would the world's most sophisticated professional investors snap up these bonds paying half a percent?

"I'm not asking rhetorically," he said. "I really don't know."

lee.schafer@startribune.com • 612-673-4302