On Wednesday, the Federal Reserve Board announced it would not currently undertake further actions to stimulate the economy. The Federal Reserve Board repeated it remains committed to keep short-term interest rates between 0 and 0.25% until at least 2014. Traditionally, this decision would be supported as a “classic monetary initiative to stimulate economic growth.” Yet this recovery from the Great Recession has proven to be far from traditional for multiple reasons.
The Great Recession began with consumers over-leveraged in credit debt carried and progressed to find 30% of the nation under-water on their mortgages. Local governments and states quickly found themselves facing previously never experienced shortfalls in tax revenue causing massive austerity measures to be implemented. Not even the $2+ trillion in combined Federal Stimulus dating back to TARP has been able to pull the economy toward traditional levels of recovery.
Today, nearly three years after the technical end of the Great Recession neither consumers nor the businesses sector are showing any signs of increasing demand no matter the record low rates available in borrowing. In today's financial reality lowering the cost of borrowing has not spurred total demand as anticipated, yet it does have a range of other unintended consequences for the economy as a whole.
Acknowledging the danger of a near-zero interest rate policy, Federal Reserve Governor James Bullard stated, “It’s a policy that may be becoming counterproductive.” James Bullard, the chief executive officer of the Federal Reserve Bank of St. Louis, says it could be a long time before interest rates get off the floor, and that could hurt the economy – and especially older bank savers.
In a Feb. 6, 2012 speech to the Union League Club of Chicago, Bullard said a policy of short-term low rates that lead to the level of current bank rates is understandable – a policy of long-term low interest rates that could be downright harmful.
Bullard seemed particularly concerned about older bank savers, who comprise the majority of certificate of deposit, money market, and interest and savings account savers in the U.S., as a continued policy of low-interest rates is really beginning to eat into their budgets since their interest return on money invested can't even keep up with inflation.
“In particular, the lengthy near-zero rate policy punishes savers in the economy,” Bullard explained. “Because of life cycle effects, most of the asset holding in the economy is done by older Americans. Recent readings from the TIPS market suggest a 10-year real rate of return of minus 30 basis points or so, and a five-year real rate of return of about minus 120 basis points.”
Low rates aren’t only hurting older Americans – they’re impacting the younger generation as well.
“In principle, the low real interest rates should encourage younger generations to borrow against their future income prospects and consume more today,” Bullard says. “However, this demographic group faces high unemployment rates and tighter borrowing constraints, which may limit its ability and willingness to leverage up to finance consumption.”
Bullard’s concerns are compounded by the additional unintended consequences of such near zero rate monetary policy such as:
• Further Bank Subsidies: The dramatic cuts in the Feds fund rate towards zero has resulted in very low funding costs for banks, now running at about 0.5% according to the St. Louis Fed. As such the banks have been able to engage in risk free arbitrage (borrow from Federal Reserve and loan to the Treasury) in order to build up reserves again. Effectively, taxpayers have continued to bail out the very banks whose “toxic loans” created the Great Recession in the first place.
• Hiding the Cost of National Debt: The Feds actions continue to soften the impact of our growing Federal Debt. In fiscal year 2011 the government ran a deficit of $1.27 trillion with the debt closing in on $15 trillion. The government's total interest expense added up to $454 billion. If the interest on the debt had equaled what we carried in 2006 – basically 2% more – our payments would have been $300 billion higher.
• Pension funds: Pension funds across the board have become more and more underfunded. Many long-term pension funds such as those for Fortune 500 companies and State Workers were established to assume an 8% rate of return on their assets that they have not realized for many years in a row. Many funds, even larger ones, are approaching funding rates of a mere 50%.
Nobel Prize winner Paul Krugman noted the following in his New York Times article “Gross Confusion,” December 20, 2011. “People have been asking me for reactions to this op-ed by Bill Gross, arguing that low interest rates are hurting the economy — an argument that he’s been making for a while now. What he seems to be saying is that low rates discourage lending, and hence make funds scarcer than they would be at a higher rate, e.g., at the zero bound, banks no longer aggressively pursue deposits because of the difficulty in profiting from their deployment. Gross seems to have joined the group of people who view current low rates as somehow unnatural, the result of policies that distort the market.”
“Unnatural” may represent the grossest – no pun intended – progressive understatement of Krugman’s career. There is nothing “natural” about the Fed’s monetary policy that has seen its portfolio grow by nearly $2 Trillion since 2009 expanding the money supply while establishing half century lows for returns on fixed investment. Today’s record low interest rates have resulted in record high levels of corporate assets being parked in “Cash and Cash Equivalents.”
David Cay Johnston reported in Reuters, July 16, 2012, “Idle corporate cash piles up” IRS data suggests that, globally, U.S. nonfinancial companies hold at least three times more cash and other liquid assets than the Federal Reserve reports, idle money that could be creating jobs, funding dividends....
The Fed’s latest Flow of Funds report showed that U.S. nonfinancial companies held $1.7 trillion in liquid assets at the end of March. But newly released IRS figures show that in 2009 these companies held $4.8 trillion in liquid assets, which equals $5.1 trillion in today’s dollars, triple the Fed figure.
Alexei Bayer wrote on the June 2012 issue of Research Magazine: "Too much cash corporate balance sheets show a troubling indicator." Classical economic theory suggests that consumers and businesses, responding to market signals such as prices and interest rates, collectively spend, save or invest their money in the most efficient manner. But the growing trove of cash on corporate balance sheets, measuring roughly $2 trillion for the S&P 500 companies, suggests otherwise.
Not only are the funds being deployed extremely inefficiently, but also the mountain of cash is in itself a troubling indication that something has gone badly wrong in the economic system. What has quickly become readily apparent is, either the business or public sector has confidence in long-term investment. This sentiment appears strongly tied to concerns relating to the asset bubble collapse that caused the Great Recession.
Fortunately, America is not the only nation to have ever suffered a severe recession caused by asset bubble’s bursting. Japan “Lost Decade 1992-2001” is generally noted to have occurred due to a combination of land and equity market collapse.
The lessons for American policymakers are clear, and it would be unwise to ignore them. An economic cycle driven by a collapse in the market for an asset -- such as land or housing -- to which the banking system is heavily exposed is a dangerous beast.
One lesson that we shall probably be learning this year is that conventional measures like prompt policy interest rate reductions by the central bank and some fiscal relief for households and firms are necessary but not sufficient conditions to return the economy to health.
Federal Reserve Chairman Ben Bernanke intently studied Japan's lost decade while a scholar at Princeton, and chided Japan's government for responding too slowly and weakly. When the U. S. economy hit similar obstacles, Bernanke's Fed deliberately avoided many of the mistakes now attributed to Japan's central bank in the '90s. The Fed cut interest rates to stimulate the economy more quickly and deeply than the Bank of Japan did.
It also took the more unusual step of buying about $1.5 trillion worth of mortgage-backed securities, pumping money into the system, and stimulating demand for other types of securities—like stocks. That action was followed by “Operation Twist” attempting to bring down long-term rates swapping short term Treasuries for longer-term issuances.
From the viewpoint of classical economic theory, the actions taken to enhance economic growth cutting interest rates and increasing the money supply should have worked. Yet something continues to hinder recovery from this recession. The Bureau of Labor & Statistics released this week that 2nd quarter growth had slowed to 1.5% from a disappointing 2.0% rate in the first quarter. These are not the type of results that the majority of economists predicted just six months ago when the 4th quarter of 2011 GNP grew over 4%.
As we approach the beginning of our 4th year since the end of the Great Recession, perhaps the Federal Reserve’s lack of action is cause to realize, there are no more actions it believes can be taken as Monetary Policy to significantly enhance economic growth.
Perhaps, America and her political leader’s need to realize that monetary policy actions are not an equivalent demand component to enhanced employment or global demand. The Fed cannot right the sinking economic ship that is the EU any more than it can directly cause hiring to increase sufficiently to pre-recession levels.
The Federal Reserve has arguably done all it can attempt to maximize the benefits of its actions while minimizing the unintended consequences of it. Repeatedly over the past two years, Chairman Bernanke has requested specific Congressional actions relating to multiple issues from the deficit to the tax code.
Two years ago, America hoped the Stimulus would restore prosperity to the nation by 2010 as the Bush Tax Cuts sun-settled. A year ago, American was told the “Super Committee” would accomplish its mission and change our unsustainable entitlement crisis while charting a new course of spending with tax reform. Today, our “Hope for Change” remains only a tarnished memory. A memory, which might still hold the key to economic recovery.