Why the Federal Reserve’s Current Low Interest Rate Policy is Bad for Americans

Historically, during periods of economic weakness, the Federal Reserve will lower the rate at which it makes short-term loans to financial firms with the hope of stimulating the economy.  By lowering interest rates, as the theory goes, the cost to borrow money falls and thus borrowers, whether individuals or companies, have more income.  This added income is then available for spending or investment and thus stimulates the economy.  Seems pretty simple.  And, in fact, it would seem that the Fed should always keep interest rates low in order to maximize income and thus spending.

If only it were that simple.  There is no such thing as a free lunch.  And, low interest rates have several negative effects.  In addition, there are instances where lower Fed interest rates don’t result in lower borrowing rates for individuals and companies.  Just because interest rates are low does not mean that people and companies can even get a loan, and thus the low interest rates actually have no positive impact.  Now is one of those times when all of these are happening.  And, I would argue that the Federal Reserve’s strategy of low interest rates actually is having a negative impact on American citizens and that Americans would be better off if the Fed raised interest rates.

NEGATIVE EFFECTS OF LOW INTEREST RATES

So, let’s start with the first negative impact of low interest rates:  while low interest rates are good for borrowers, they are horrible for seniors, savers and pension funds.

1. America’s seniors and retirees primarily live on their savings.  It is not prudent for them to invest in risky assets such as stocks but instead they should invest in low risk assets such as CDs, money markets and maybe US government bonds.  But, what is the rate on a money market these days?  Three to four years ago, you could earn 5%.  Today, you earn maybe 0.06%, or effectively nothing.  CDs are not much better and CDs require money to be tied up.  The Fed’s low interest policy is devastating to seniors and retirees.
2. Similar to seniors, America’s savers are also negatively impacted by low interest rates.  You pay off your credit card every month, you have a 30 years fixed interest mortgage and you save for your future.  What do you get in return from the Fed?  A kick in the groin via near zero interest rates on your cash.  Instead, you are forced to invest in much riskier assets if you want to earn any income, which may be great for the stock market but not for prudent savers.
3. Pension funds need to invest the premiums they receive in order to satisfy the payouts.  They hold a variety of assets, including a large proportion in bonds.  And, low interest rates are a killer for the income they earn on the bonds.  One of the reasons that pension funds are so underfunded is the Fed’s policy of low interest rates.

Another negative impact of lower interest rates is that it reduces the value of the US dollar compared to other countries’ currency.  In simple terms, a lower US dollar reduces what you can purchase with that dollar, otherwise known as inflation.

Let’s look at just how devalued the US dollar has become.  When compared to other major currencies, in the past 10 years the US dollar has lost between 30% to 50% of its purchasing value.  That is not a typo.  For example, ten years ago, US$1 bought 1.11 Euro.  Today, US$1 will buy 0.72 Euro, which is a 35% decline.  Likewise, ten years ago, US$1 bought 120 Japanese Yen.  Today, US$1 will buy 76 Japanese Yen, a 37% decline.  Similarly, versus the Canadian dollar, the US dollar is down about 32% over the past ten years and versus the Australian dollar the US dollar is down an eye popping 52%!  And, as I will soon explain, this makes everything American’s buy more expensive.

To be intellectually honest, the decrease in the value of the US dollar results from several factors, including the perceived risk of the US government’s ability to repay its debts.  But, Japan’s national finances are even worse than the US’s, and we are all following Europe’s fiscal problems, so the US’s fiscal situation is actually better than Japan’s and Europe’s and yet the US dollar is down by a third compared to them.  Another factor that influences the value of a currency is the simple printing of money.  Recently, the Fed has endeavored on a series of Quantitative Easing policies, which is printing money, and which definitely have decreased the value of the US dollar.  Discussing QE is too detailed a topic for this discussion, but I did want to acknowledge its impact on the value of a currency.  And, for fun, here is a link to a video that parodies the QE policy, http://www.youtube.com/watch?v=PTUY16CkS-k.  I highly recommend you watch it.  Regardless, though, cuts in US interest rates are still a contributor to the decline in the value of the US dollar.

A lower dollar benefits companies that make goods in the US and then export them overseas because the products are less expensive to the other country that is buying them.  But, it also works in reverse making products imported into the US more expensive.  Also, all commodities, such as oil, grains, metals, etc. are priced globally in US dollars.  So, when the value of the US dollar falls, the price of commodities increases.  Americans’ prices of gasoline at the pump, food on the table, etc. are all more expensive because of the decrease in the value of the US dollar.  Frustrated with the price of gasoline?  Don’t blame the oil companies.  Oil is a global commodity and the oil companies are small players in determining the price.  No, if you want to blame someone blame the Federal Reserve.  By decreasing the value of the US dollar, they cause gasoline prices to increase via higher prices for oil when bought with the devalued US dollar.

I did mention that a lower currency helps American exporters be more competitive with global competition.  And, there are those that say without the low US dollar that the US cannot compete, which would result in layoffs of workers as manufacturing moves overseas.  In theory, I understand that argument.  But, then explain to me Germany.  Germany uses the Euro which is up 35% versus the US dollar in the past 10 years.  Yet, Germany is an export machine, whether within Europe or to Asia and the US.  Germany is extremely competitive and German companies manufacture products mostly in Germany.  And, for that matter, you can make the same argument about Japan, where the Yen is even more highly valued against the dollar than the Euro versus the dollar.  And, yet, Japan is still an exporting machine.  There are many reasons why Germany and Japan are such strong exporters despite the burden of their highly valued currencies, but the point for the US is that a highly valued currency is not an excuse for an inability to be competitive in a global economy.

Based on the above, I hope you are asking yourself why then the Fed maintains this low interest rate policy.  There are three immoral reasons, as well as one that I understand but with which I disagree:

1. The US government has about $10 trillion in public debt upon which it must pay interest. Over the past 30 to 40 years, the average rate on US government debt has been about 5.5%.  Currently, it is about 2.8% due to the Fed’s low interest rate policy and the US Treasuries’ bias toward short-term borrowing versus longer-term borrowing.  At normal rates, annual interest expense on the national debt would just about double from $266 billion to about $523 billion annually.  Thus, the Fed is helping Washington politicians from having to make the hard decisions regarding the unsustainable annual budget deficits.
2. The American public amassed huge amounts of debt over the past 10 years and is struggling to pay it down.  At normal interest rates, the monthly interest payments would overwhelm people.  Thus, the Fed is helping overly indebted Americans make their interest payments via low interest rates.  But, what about the Savers?  The savers get totally screwed in the process.  It is immoral that the Fed sets a policy that bails out the profligate to the detriment of the prudent.
3. And, finally, no surprise that the Fed is bailing out America’s banks.  Low interest rates enable banks to pay very low rates for deposits, money markets and CDs, or just borrow directly from the Fed.  The banks can then take this money upon which it pays almost nothing and reinvest it at much higher rates in risk-free assets such as US government debt.  It’s a total scam.  But, the Fed considers this necessary because the banks incurred heavy losses due to the housing collapse, and now the banks need help to rebuild their balance sheets via increased profitability.  This is completely immoral and makes me angry.

LOW INTEREST RATES ARE IRRELEVANT IN HIGH DEBT ENVIRONMENTS

In the prior paragraph, I stated I understand one reason for low interest rates but I don’t agree with it.  And, a common sense example will help.  A friend approaches you and asks to borrow $10,000.  Your friend has a good stable job, you know he has good character, and you know that he has very little personal debt.  So, you have every confidence that he will be able to repay the loan and thus it just boils down to a question of the interest rate.  Now, let’s consider a second scenario.  Another friend wants a loan but this friend has a huge balance on his credit card, is upside down on the mortgage of his house, is at risk of being fired from his job.  At what interest rate would you make the $10,000 loan?  Exactly.  At no interest rate would you make the loan because the likelihood of being repaid the loan is so remote that no amount of interest can compensate for the risk.  And this, my friends, is the situation today for the US.  Banks and other financial institutions are more focused on recovering principal than the interest income on the loan they will receive.  This is in part why it is so hard to get a new loan on a house.  Thus, interest rates don’t really matter.  And, this means that the Fed policy of lowering interest rates will not stimulate an economy that is going through a de-leveraging after a property bubble.

PULLING IT ALL TOGETHER

The Fed applies dogmatic, antiquated thinking to its policy-setting.  They are like robots.  There is a recession so they must stimulate.  That is all they know.  But, why is there is a recession?  Is it because there is a lack of demand?  Then, OK, stimulate (actually, don’t stimulate because all the Fed does is create booms and busts, but at least I can understand why the Fed would think stimulating is a good idea).  But, if the recession is because of a de-leveraging, then low interest rates will not stimulate the economy since lenders are most focused on avoiding losses.  And, at the same time, the low interest rates hurt savers via low returns on their cash and the low interest rates hurt the value of the US dollar which causes price inflation.

So, the Fed should actually increase short-term interest rates.  Seniors, retirees and savers will have more income to spend, which actually is real stimulation to the economy because it’s the creation of real demand.  The value of the US dollar will increase, resulting in lower prices for commodities and thus lower prices for gasoline and food.  And, the increase in interest expense on the national debt will push elected officials to work toward a solution to the fiscal mess the government faces.  Counter-intuitively, you could actually see a situation where banks are more interested in making loans because they will not be able to take in low cost deposits and then just invest in longer-term US treasury debt and other higher yielding assets.  In any case, the banks won’t decrease lending as a result of higher short-term interest rates.  Finally, it’s the fiscally responsible, moral thing to do.

At the beginning of this post I mentioned there is no such thing as a free lunch.  And, increasing interest rates and the resulting increase in the US dollar will not be pain free.  US multi-national corporations will be negatively impacted because such a large proportion of their sales and profits are from overseas markets in local currencies.  And, those local currency sales and profits will be lower when converted back into the more highly valued US dollar.  Thus, corporate earnings will fall and most likely stock prices for publicly traded US multi-nationals will decline.

When looking at all the pros and cons of low interest rates, it seems pretty clear that the Fed should raise interest rates.  The question, then, is how do we get the Fed to question everything they have learned in text books for the past 40 years?