The Fed's Low Rates Are Restraining Recovery

In May 2010 I wrote an Op-Ed for the Wall Street Journal arguing that the Fed's low interest rates were actually retarding economic recovery and job creation, not assisting it. Since then, this view has been gaining traction, albeit not at the Fed.

The prevailing view among economists, policymakers and Federal Reserve Board governors -- and the conventional Washington wisdom more broadly -- remains that zero or near-zero short-term interest rates (negative 2% in real terms) have some unavoidable adverse side effects, but unquestionably stimulate the economy.  Put more simply, the lower the rate, the more economic stimulation.

The Fed believes that higher asset prices, particularly higher stock prices filter down to increased consumption, and therefore more job creation. It believes that recapitalizing the banking sector through low interest rates results in greater access to credit, more company formation, and once again more jobs. Finally the Fed believes that it will be able to rein in any resulting asset bubbles down the road once the economy recovers.

The pernicious impact of near-zero short-term interest rates on asset prices and inflation and the massive misallocation of investment dollars resulting from the policy is now well disseminated.

About the above, it should be said that the Fed is aware of the adverse side effects of its policies. It is also aware of the adverse impact of high unemployment on the jobless, the social fabric of the country and the economy, and the especially devastating impact of prolonged high unemployment. The Fed believes that the adverse side effects are an acceptable cost of a medicine that is otherwise encouraging growth, creating jobs, and supposedly curing the patient.

But what if as opposed to stimulating the economy and creating jobs, near-zero rates are actually deterring recovery by retarding consumption, deterring lending and job-producing investment, and undermining confidence; thus authoring a slower recovery and less job creation than would otherwise be the case?  The continued anemic nature of the present recovery compared to that from prior recessions at the very least indicates the need for an urgent reexamination of the Fed's policy.

Once interest rates go below a certain level the negative impacts outweigh the presumed positives and recovery is actually impeded.

Specifically, the Fed's policy:

• Causes a massive, hidden and unprecedented transfer of wealth. The money comes from savers and retirement accounts, sponsors of defined benefit pension plans, beneficiaries of endowments and foundations that generally have a high consumption coefficient of income. The beneficiary of the wealth transfer has to a great extent been the financial sector which has used the transfer to strengthen its finances and compensate its already highly paid employees.

This transfer of wealth is on the order of $600 billion. And while the impact on households is somewhat mitigated by the reduction in mortgage interest and other debt costs, the negative impact on pension plans, insurance companies and endowments is substantial even after the increase in stock prices. The financial sector beneficiaries have shown a lower consumption rate than the investors who have forgone income.

• Results in negligible returns on savings, which stresses consumers, pension plans, retirement accounts, endowments, foundations, trusts and companies with cash.  The latter stresses are delaying the restoration of confidence - a key to recovery.

• Deters lending to job-producing middle market and smaller companies by producing a steep yield curve on government and comparable debt, allowing investors and banks to earn a more than ample return without effort, expense or risk.

In human terms, the Fed's policy means emergency room nurses in Texas are working longer hours to make up for low yields on CDs, dairy farmers in Iowa are forgoing equipment purchases to save more for retirement, charities for the homeless in Manhattan are reducing services as foundations cut grants, and local governments from Albany to Sacramento are closing libraries to fund pension plan deficits. Across the country, Americans are struggling to subsidize the well paid bankers on Wall Street.

The other goal of the Fed's policy (together with the resulting steep yield curve on government debt) as previously mentioned is to provide a backdoor means of recapitalizing the financial system, thereby increasing lending and spurring job-producing investments. There is no question the financial sector is thriving.

But there are few signs of all this expected activity because the beneficiaries of the Fed's wealth transfer are just not following the playbook. Overleveraged consumers are not spending or buying homes for a small discount on mortgage rates, and financial institutions are not increasing job-creating lending. Instead, financial institutions are paying employees record bonuses and generating record returns for shareholders.

The Fed claims there is no statistical evidence of a lack of credit availability. Certainly credit is readily available to larger companies. However, it is less available for the middle market and smaller companies that are historically responsible for job creation in the U.S.

It is certainly true that large, credit-worthy, or too-big-to-fail companies are able to borrow at very low rates. But this is not leading to materially increased investment. Almost every large company CFO will tell you that slightly cheaper credit has little impact on most investment decisions. Increased demand and growth prospects are far more important.

What is especially frustrating is that supporters of the zero interest rate have a stark example of the policy's failure staring them in the face: Japan. Following the bursting of its credit bubble in 1990, Japan eventually brought its equivalent of the Fed rate down to a then-unprecedented 0.25%. The nation proceeded to suffer a "Lost Decade" of economic stagnation that has never really ended.

It is accepted wisdom among economists that this happened despite the stimulative benefit of zero percent rates, and that the Bank of Japan's colossal mistake was not bringing them down fast enough. Fed Chairman Ben Bernanke has studied the Japanese crash and believes this interpretation. In short, he does not question whether zero percent rates contributed to the Lost Decade.

In fact, Japan got caught in a cycle in which zero interest rates led to anemic private consumption and investment. The Japanese government then made up for this private sector shortfall by borrowing and spending.

Ironically, the borrowing was facilitated by the same zero percent rates that caused the private sector shortfall. National debt ballooned, eventually making it perilous to raise rates, thus trapping Japan in a cycle of depressed consumption and investment prompting more spending and borrowing to keep the economy afloat.

Of course the U.S. is not Japan. We have a far more robust economy and Japan has its own issues. But, the impact in terms of higher unemployment and slower growth is the same.

To avoid this trap, and to encourage private sector demand growth and flatten the yield curve to stimulate productive lending, the Fed should begin to raise short-term rates.

From a public policy perspective, rising short-term rates will begin to reverse the current imbalance caused by the massive wealth transfer from private owners of investment assets to banks and non-productive borrowers.
From a recovery perspective, increased returns on cash will cause Americans to feel more confident about their economic future.

Paying higher rates to attract deposits and a flatter yield curve on government debt will force banks to look for lending opportunities beyond government type credits. Investors, companies and banks will also become less tolerant of underperforming assets and seek to move those assets more swiftly to superior owners and operators, creating additional efficiencies and job-creating growth.

Yes, there are risks. First of all, I am recommending raising short-term rates only - and only from zero to a reasonably low level. Second, the current policy is not working.

The Fed remains committed to zero percent rates in the sincere but mistaken belief that this will assist the recovery. By this commitment, however, it is undermining the very recovery it seeks to create. Contrary to conventional wisdom, raising short-term interest rates from current levels would increase consumption, productive lending and job-creating investment, helping to restore confidence and get the long-awaited recovery going.