Tuesday, August 10, 2010

The Benefit of Low Low Interest Rates --- what am I missing?

The first thing that I'm missing is any income of consequence on safe savings. That's not really important. What does the economy gain from this Fed commitment to negligible interest rates. That's the question.

There are three big issues for the economy right now - unemployment, credit availability, and business investment. Today the Fed announced that interest rates would remain low for an extended period of time and that it would be in the market to buy Treasuries rather than allow any run off from its mortgage securities portfoliio to reduce the Fed balance sheet. Will this action help create new jobs and reduce unemployment? NO. Will it make credit more widely available? NO. Will it lead to more business investment? NO. What it does is maintain excess liquidity in the banking system and demonstrate the Fed's willingness to act aggressively to address any systemic liquidity freeze-ups.

Chronically low interest rates penalize those who save or those who are living off of assets saved over a lifetime of work.

These low interest rates encourage risk taking as savers who need some yield move out the risk spectrum. That could lead to bubbles over time - bonds, munis, emerging markets debt, high yield debt, hybrid mutual funds that supposedly offer a balance of high yield securities and U.S. government securities, there's more that could bubble up and ...

This interest rate policy provides a free lunch for banks who pay almost nothing for their deposits and can lend at historically low rates but still have wide spreads. Even easier, banks can simply sit on the money as well, arbitraging short term almost free money into government and interbank lending programs that guarantee an almost risk free spread that pays the bills. This can discourage banks from doing the work to move beyond the safest credits in order to gain business or market share. Already large corporates with cash who have no great need for loans have ready access to the banks while entrepreneurs and small businesses need to offer up their first born to get in the door.

Business investment is on hold as economic uncertainty and the still fresh memory of the last two years of trauma linger. New regulations being digested and no firm guidance on tax protocols for even 2011 create more hesitancy. These issues cannot be addressed by low interest rates.

While this writer is no economist or policy expert, far from it, from this perspective it looks like the Fed's policy does nothing to help anything get better. Its purpose is to prevent the economy from getting worse. It's like the results of the stimulus money that purportedly saved X number of jobs even though unemployment numbers continued to climb.

While markets enjoy short term solutions, in the short term, the case could be made that the Feds interest rate policy is locking in the current negatives in a trade-off for stability at this lousy level. If the inflation that is almost inevitable begins to pick up before the policy gurus are prepared, we could have the worst of two worlds - recession and price increases for necessities.

Maybe policy folks should stop worrying about a Japan of the 90's deflation. The U.S.A. is not a homogenous society that moves in lockstep and breathes acceptance. The bet here is that we'll inflate, and it could get messy.


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