The macroeconomic case for maintaining interest rate stability: Implications for commercial real estate.

In an era of heightened economic uncertainty, there is increasing advocacy for interest rate cuts to stimulate short-term growth. The commercial property sector, in particular, has been vocal in its call for lower borrowing costs, which would ease capital flows and enhance asset values. However, from a broader economic perspective, it is imperative to consider the long-term ramifications of accommodative monetary policy beyond the immediate benefits.

Monetary policy should not merely react to cyclical pressures but also safeguard the broader macroeconomic stability necessary for sustainable economic growth. In this article, I will argue that, despite widespread calls for rate cuts, maintaining stable and "healthy" interest rates is critical for preventing asset bubbles, ensuring prudent investment behaviour, controlling inflation, and promoting long-term financial stability in the commercial property sector.

Monetary Policy and Commercial Real Estate: A Fragile Equilibrium.

Monetary policy operates at the intersection of aggregate demand management and financial stability. Interest rates influence various economic behaviours, including saving, borrowing, and investment. In commercial real estate, they determine the cost of capital, affecting property values, investment decisions, and market liquidity. While a reduction in interest rates may provide immediate liquidity to the property market, the longer-term impact of artificially low rates should be evaluated in terms of sustainability.

1. Asset Overvaluation and the Risk of Bubbles.

A well-documented consequence of protracted low interest rates is the risk of asset price inflation. Low borrowing costs can artificially inflate property values in the commercial property market, leading to asset overvaluation. When investors are incentivised to pursue yield at any cost due to cheap capital, the market may experience mispricing of risk. This phenomenon, identified in economic literature as the "search for yield," can lead to speculative behaviour, driving prices beyond their fundamental values.

In this context, artificially low interest rates create the conditions for asset bubbles. Reinhart and Rogoff (2009) noted that such bubbles can precipitate sharp corrections when interest rates normalise, with severe consequences for financial stability. For commercial property, this implies a destabilisation of market values, leading to potential crises similar to those witnessed during the Global Financial Crisis 2008, where overleveraged property sectors were hit hardest by market corrections.

2. The Role of Interest Rates in Discouraging Speculative Investment.

From an investment theory perspective, commercial property is a long-term asset class where the decision-making process should account for future income streams and associated risks. Excessively low interest rates distort this process by lowering the cost of speculative ventures. Investors may be inclined to enter the market without fully considering the long-term viability of their projects, thus skewing the market toward high-risk undertakings.

In his seminal work, Keynes (1936) warned against the speculative "animal spirits" that can dominate markets when interest rates fall below a certain threshold, disconnecting asset prices from their underlying value. A stable interest rate environment acts as a disciplining mechanism, compelling investors to carefully assess their ventures' long-term profitability and risk profile. This, in turn, promotes the efficient allocation of capital—a key tenet of classical economic theory.

3. Inflationary Pressures and Cost Escalation.

The relationship between interest rates and inflation is well-established in the literature (Taylor, 1993). Low interest rates, particularly when maintained over a prolonged period, tend to stimulate aggregate demand, increasing upward pressure on prices. While inflation may seem less pressing in the current global economic environment, inflationary risks remain significant, particularly in the context of supply-side shocks and labour market rigidities.

For the commercial property market, inflation manifests not only in asset prices but also in operational costs. Rising construction, maintenance, and management costs can squeeze profit margins for property owners, particularly in cases where rent escalation clauses in commercial leases lag behind inflation rates. Simultaneously, tenants face increased operating expenses, potentially leading to higher vacancy rates and tenant defaults. In the absence of real income growth, inflation erodes the profitability of commercial property investments, undermining long-term returns.

4. Over-leverage and Systemic Financial Risk.

Low interest rates also encourage borrowing, often leading to excessive leverage in the property sector. While debt-financed investments may seem rational in an environment of low rates, they amplify systemic risks in times of economic stress. The over-leverage problem is particularly acute in the commercial real estate sector, where large-scale investments require significant capital outlays.

Minsky's (1986) Financial Instability Hypothesis provides a compelling framework for understanding the relationship between low interest rates, borrowing, and financial fragility. Minsky posited that prolonged periods of financial stability, characterised by low interest rates, encourage borrowers to take on increasing levels of debt, eventually leading to a point of instability. Even modest rate hikes or exogenous shocks can trigger widespread defaults and a subsequent financial crisis in this scenario.

By maintaining a stable interest rate policy, central banks reduce the likelihood of excessive debt accumulation in the commercial property sector. Investors are encouraged to balance equity with debt financing, thereby reducing the risk of insolvency in economic downturns.

5. The Long-Term Growth Imperative.

The economy's productive capacity ultimately determines economic growth, and monetary policy plays a key role in fostering an environment conducive to sustainable growth. While rate cuts may provide a short-term boost to economic activity, they often fail to address underlying structural economic issues.

In the context of commercial real estate, long-term growth is driven by more than just the availability of cheap capital. Instead, it is predicated on the strength of the real economy, the productivity of businesses that occupy commercial spaces, and the overall health of the labour market. By maintaining stable interest rates, central banks help avoid the misallocation of resources and encourage investment in sectors that contribute to sustainable economic growth, such as infrastructure, technology, and human capital development.

Conclusion: The Need for Prudence in Monetary Policy.

The clamour for interest rate cuts, particularly in the commercial property sector, is understandable, given the short-term benefits of lower borrowing costs and increased liquidity. However, from an economic standpoint, the long-term consequences of yielding to such pressures can be profound. Asset bubbles, speculative investments, inflationary pressures, and systemic financial risks pose significant threats to economic stability.

Maintaining healthy interest rates, despite external pressures, is critical for preserving financial stability and promoting sustainable growth in the commercial property market. A disciplined monetary policy encourages prudent investment behaviour, discourages over-leverage, and fosters a stable macroeconomic environment that benefits not only property investors but the economy as a whole.

In conclusion, the central tenet of monetary policy should be stability, not reactivity. As the famous economist Milton Friedman once said, "There’s no such thing as a free lunch." Interest rate cuts may provide immediate relief, but they come at a long-term cost to economic health. A stable interest rate policy is essential for ensuring the resilience and sustainability of the commercial property sector and the broader economy.