Been Pondering the Low Rate Policy Awhile

Posted by Jeff Carter
on June 11th, 2010

I am uncomfortable with the quantitative ease and ultra low rate policy the Federal Reserve is pursuing. It has not proven to be inflationary yet. Also, modern economic theory would point policy in the direction of low rates. Essentially, the “price” of money has fallen to just about zero. This should increase the demand. On the supply side, the Fed is printing money. However, the money isn’t being recycled into the economy. It’s accumulating on company balance sheets, and both companies and banks are reinvesting the money into short term treasuries, keeping government borrowing costs low.

This is unnatural. The artificial low interest rate environment has persisted off and on since December 1999, when Greenspan and the rest of the world had a fear of computers crashing everywhere. Ask any treasury trader how the futures contracts for December expiration traded and they will shudder. Thin, moving at will, they were untradable.

In his blog, Raghu Rajan makes the case for raising interest rates. I would add to that. Raising rates will increase the cost of government borrowing, and theoretically should decrease the appetite to spend. Higher rates will make all government spending more expensive.

Certainly, the ultra low rates are not free. Always there are opportunity costs no matter what you do. Rajan worries that banks will begin to use the ultra low rates to assume more risk. I disagree. Banks have no appetite for risk. What really needs to happen for things to turn is banks need to lend that money out into the broader economy. Today, they simply invest it risk free and earn 3%. If rates went up, banks might allocate portions of their lending portfolio to chase yield in the private market. I think there is enough short term demand for US Treasuries to keep rates low for a fixed period of time. I am only worried about rate increases when money starts to turn over in the economy, or unemployment drops significantly. Until then, we will be in a low inflationary environment.

Increasing rates will also strengthen the dollar. Strong economies are not built on weak currency. American’s are generally consumers of world goods. We don’t manufacture. The manufacturing that we do, along with the services we provide are high value in demand goods. Higher dollar prices when the currency appreciates won’t affect demand for them that much.

Raising rates might also increase confidence. Extremely low rates are a sign of economic weakness. Raising them might induce businesses to act. The Fed at their next meeting should think about a half point rise in the discount rate. That would shock the system.

However, I am very mindful of the 1930′s. Government increased spending, increased taxes, and increased rates. It killed the economy. Only World War Two lifted us out of the Depression. The government should not raise rates without a corresponding cut in some taxes, along with massive cuts in discretionary spending. If they did that, things would certainly improve.

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