The dark side of low interest rates



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What do the Federal Reserve and a Ouija board have in common? Both are equally adept at predicting the economic state three months from now. So when the Fed recently announced its intent to keep interest rates near zero for several more years, I could only chuckle.Announcing a long-term forecast is part of Chairman Ben Bernanke's desire for greater transparency. A noble goal, but given the Fed's forecasting track record, perhaps not a wise one.No matter, the financial markets habitually disregard reality so Wall Street will take the Fed at its word. And why not? Equities love low rates, as they tend to drive investors from low-yielding investments like bonds into equities. Although this time the lingering fear of capital loss has stunted that migration.Low rates also allow heavyweight investors to play the carry trade. Frequently currency-related, a carry trade is the act of borrowing cheap money to buy higher yielding investments. Home and car buyers and holders of adjustable rate mortgages all obviously benefit from cheap money. And low rates have been a boon to the mortgage refinancing market.But are low rates universally beneficial? That would be a no.Consumers who borrow benefit, but savers suffer from a virtual zero return on money parked in savings accounts and CDs. This is a particularly acute problem for retirees who tend to put a larger portion of their savings in safe, lower-yielding investments.Some estimates have the aggregate loss of interest income over the past three years at $616 billion, or about 70 percent of the value of the 2009 stimulus package. And the loss of aggregate interest continues at a clip of about $20 billion a month.Bank profits are being squeezed from narrower spreads. Bank spreads are the difference between the cost of money and loan rates. Smaller banks, like community banks, feel the pain to a greater degree because they derive the bulk of their revenues from loans.Banks garner little sympathy these days, so who cares if their profits decline? Well, you should, because there are unintended consequences.A recent conversation with a local banker confirmed what I suspected. Low rates are great for the most creditworthy, but shrinking loan margins have created an "only the safest" loan mentality. The result is tight credit. Face it: How anxious would you be to lend money for 30 years at less than 4 percent?Tight credit is one reason home sales have struggled to gain traction. Tight credit also affects a group more important to the economic recovery: small business.It's hard to gauge the level at which this is stifling small business growth, but given small businesses are our primary employment engine, any headwinds they encounter hurt growth.On the flip side, big businesses can garner productivity gains by using cheaper money to buy machinery and technology. And the numbers bear this out. The only problem is increased productivity also means fewer jobs. I'm not advocating lower productivity, but it's important to understand all of the actions and reactions.Despite lackluster results since 2008, the Fed hopes maintaining low rates will spur investment, spending and growth. Evidently, the Fed believes the old adage, if at first you don't succeed ....Is it possible slightly higher rates might yield a better result? Yes, except you won't find this counter-intuitive strategy in any textbook, just in a world in which the Federal Reserve doesn't reside: the real world.Author, professor, economist and entrepreneur, Tony Paradiso of Wilton is a marketing and management expert.

 

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