For the first time in nearly two decades, interest rates are behaving normally. The era of zero interest rate policy (ZIRP), which lasted from 2008 to 2022 with only a brief interruption in 2018-2019, is over. As of March 2025, the federal funds rate sits at 4.25-4.50%, the Bank of Canada’s overnight rate is 3.75%, and the European Central Bank’s deposit rate is 3.25%. These are not high rates by historical standards — the average federal funds rate from 1955 to 2007 was approximately 5.4% — but they represent a paradigm shift from the post-2008 world that shaped an entire generation of investors.
Why ZIRP Changed Everything
When the cost of borrowing is effectively zero, the rational behaviour of investors changes in predictable and distorting ways. Companies that could not generate positive cash flow were able to raise capital indefinitely because the alternative — holding bonds yielding 1% or less — was so unattractive. Venture capital flooded into startups with no path to profitability. Real estate appreciated because mortgages were cheap and cap rates compressed. Stock valuations expanded because the discount rate applied to future cash flows was minimal. The entire ecosystem of “growth at any price” investing was an artefact of zero interest rates, not a permanent feature of markets.
The transition away from ZIRP has been painful. The S&P 500’s forward price-to-earnings multiple compressed from 23x in late 2021 to roughly 18x in late 2022 before rebounding on AI enthusiasm. The IPO market, which averaged over 400 deals per year from 2020 to 2021, collapsed to fewer than 150 in each of 2023 and 2024. Venture capital deal volume fell 40% from its 2021 peak. These are not anomalies — they are normalisations. The financial system is relearning how to price risk when capital has a cost.
The Inflation Picture
The US Consumer Price Index (CPI) peaked at 9.1% year-over-year in June 2022, the highest reading since 1981. By February 2025, it had fallen to 2.8%, closing in on the Fed’s 2% target. The Personal Consumption Expenditures (PCE) index — the Fed’s preferred inflation gauge — tells a similar story, having declined from a peak of 7.1% to 2.5%. Core PCE, which strips out volatile food and energy prices, has been stickier at 2.8%, reflecting the stubborn persistence of shelter costs and services inflation.
The Bank of Canada has made similar progress. Canadian CPI peaked at 8.1% in June 2022 and has since declined to 2.6%. The Canadian economy faces additional headwinds from a heavily indebted household sector — Canadian household debt as a percentage of net disposable income is approximately 180%, compared with roughly 100% in the United States — making it more sensitive to interest rate policy.
The great debate among economists in early 2025 is whether inflation will continue its gradual decline or become entrenched at a structurally higher level. The optimists point to normalising supply chains, declining shelter inflation (rents are rolling over in real-time data from Zillow and Apartment List even as the CPI shelter index lags) and the disinflationary force of AI-driven productivity improvements. The pessimists point to rising energy prices, deglobalisation (reshoring of manufacturing, which increases costs), structurally tight labour markets and the growing fiscal burdens of governments that may resort to inflationary financing. The truth likely lies somewhere in between, which means rates are unlikely to return to zero but also unlikely to spike dramatically higher. The 2025 consensus among major central banks points to gradual rate reductions — perhaps 50-100 basis points of cuts spread over 12-18 months — rather than a rapid unwinding.
What This Means for Investors
A normal interest rate environment rewards fundamentally different behaviours than a ZIRP environment. Companies that generate free cash flow are valued more highly than companies that promise to generate it eventually. Fixed income — bonds, GICs, Treasury bills — once again provides meaningful income, with 10-year US Treasury yields around 4% and Canadian government bonds yielding approximately 3.25%. This represents genuine competition for equity capital that did not exist during ZIRP.
Asset allocation — the most important investment decision most people make — requires rethinking in this environment. The classic 60/40 portfolio (60% stocks, 40% bonds) produced its worst year in decades in 2022 when both stocks and bonds fell simultaneously, but it has performed well since as bond yields have normalised. Diversification across asset classes, geographies and currencies becomes more important when correlation patterns are less predictable. And cash — long derided as “trash” in the ZIRP era — now earns 4-5% in high-yield savings accounts and money market funds, providing a genuine option value: the ability to deploy capital when opportunities arise. Investing in a world with positive real interest rates is fundamentally different from investing in a world without them. The adjustment process has been painful. The destination is healthier.