Why we could pay a price for low interest rates

Here’s the key line from the U.S. Federal Reserve’s latest policy statement on July 27: “Near-term risks to the economic outlook have diminished.”

It has been a while since the Fed has dared to look out the window. First it was China that forced the central bank to scrap plans to raise interest rates. Then came Brexit. But global financial markets have held up since the United Kingdom voted to quit the European Union. Before the new statement, only a betting man or woman would have said higher interest rates were likely in 2016. Now, an interest-rate increase before the end of the year is a distinct possibility.

Bond yields shot higher, and the dollar rose. That’s what happens there are hints borrowing costs will rise. Oddly, it didn’t last. Yields reversed course and the dollar weakened. According to Tom Porcelli, chief U.S. economist at RBC Capital Markets, market prices imply the odds that interest rates will be higher at the end of the year are less than 50%. What’s going on? It appears there are a lot of traders out there who doubt the Fed has the guts to raise interest rates.

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Brexit Pollyannas trumpeted buoyant stock markets as evidence they were right to dismiss the gloom that followed the referendum result. Their triumphalism ignored the fact that British equities rallied because almost everyone expects the Bank of England to push interest rates lower. Almost everyone expects the Bank of England to do this because the uncertainty caused by the referendum debate and the result likely caused a recession. Stock markets are stronger because traders realize British investors will have no better place to put their money for a long, long time.

The European Central Bank also is widely expected to amp up its stimulus program, and the Bank of Japan could do the same. The Fed might like to raise interest rates this year, but it will find itself jammed. When it raised its target from zero in December, the dollar surged. That hurt exporters and crimped business investment. Near-term risks have diminished because central banks are set to extend the era of cheap credit. The Fed won’t follow its peers, but nor will it lead them back to a more typical interest-rate setting. At least not yet. That’s the bet. If the markets are wrong, Fed chair Janet Yellen is going to have to convince them.

Aggressive monetary policy probably is necessary to avert catastrophe, but it is altering economies in subtle ways that could hurt in the future. Consider the UK. Equity markets may have recovered from their post-Brexit collapse, but the pound sterling has not. A weaker currency allowed Japan’s Softbank to purchase the darling of Britain’s technology industry at a steep discount. There surely will be others. The hollowing out of British industry could unnerve a population that just voted to leave the EU because it felt it lacked control of its economic destiny.

Let’s bring this discussion closer to home. The housing bubbles in Vancouver and Toronto—just like the bubbles in Sydney, Hong Kong and others —are the result of ultra-low interest rates for longer and longer and longer. Those bubbles aren’t a reason to raise borrowing costs; you don’t hurt the prospects of the broader economy to contain a mania in a couple of big cities. But something needed to be done. British Columbia’s new tax on foreign purchases of homes in Vancouver is the first serious attempt by local authorities to confront a local problem. Will it work? Stewart Beck, the head of the Vancouver-based Asia Pacific Foundation of Canada, thinks so. Jason Kirby, business editor at Maclean’s, reckons super rich Chinese will simply pay the tax and carry on as before. Both Beck and Kirby agree that someone should have tried to do something about the problem long before now.

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I’m inclined to think the tax will take the froth out of the Vancouver market, but not in a positive way. Kirby is right; Asia’s super rich will pay the tax, assuming they are motivated by putting their wealth under the protection of Canada’s respect for property rights. But do you know who won’t pay the tax? Non-Canadians who wanted to move to Vancouver to become rich.

International plutocrats do almost nothing for local economies by buying a house. Economic immigrants do a great deal. They allow startups to scale and they start companies of their own. That begets more hiring and investment. The tax base grows. Forget about the contribution of housing to gross domestic product. Canada has a productivity problem, B.C. included. Real-estate investment does almost nothing to boost productivity. Technology and manufacturing drive innovation. And B.C. has just made it more difficult for those industries to attract talent. It already was expensive to lure young engineers to Vancouver. It is even more so now.

This article was originally published on Canadian Business.