The negative allocative effect of low interest rates will increases as rates go higher. Simply put, the allocative effect of monetary policy is that when rates are very low for a long time (zero rate policy), investment decisions and behavior will be distorted. There are two negative effects.
One, investors will reach for yield and invest in project that have a lower return because the risk free rate alternative is so low. For short periods, this may be a good thing for the economy, but over longer periods, investors will reach for investments that have less cushion for error. A project that has a low IRR will have a higher likelihood that the investment will lose money if something goes wrong. The margin for safety is low.
Two, firms will have a lower acceptable return on capital. Again, the alternative is an extremely low risk free rate.
As rates rise, all of these marginal projects and companies will no longer be profitable or be underwater. They were able to borrow at low rates and still have a low return on capital. Borrowing costs will increase as rates rise, but the return on capital may be the same. Defaults will increase because the slightly profitable company of yesterday will be unprofitable today and will be even less profitable tomorrow.
I can get bad about inflation, but I worry about the negative allocative effect because that will take the economy into a recession not based on slowing aggregate demand but based on bad investments.
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