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Is anyone besides me worried that keeping interest rates low may be bad policy? Is anyone worried that that in the longer run, keeping rates low may lead to further economic stagnation?

The prevailing theory seems to be that low interest rates when the economy is soft will promote business investment and consumer demand. Business investment is expected to lead to more jobs, and consumer demand drives the economy.

Is all that True?

Or, more to the point, is all that true after three years of rates close to zero?

No, it does not appear to be true. Businesses appear to be responding to their perception of demand, not to the rates at which credit is offered. American banks have plenty of money to lend. But (a) many businesses do not want to borrow because they do not see increasing demand for their products, and (b) many large businesses find it preferable to borrow longer term in the bond market. Even worse from an employment point of view, if businesses borrow, are they not likely to borrow in order to increase efficiency? Are they not likely, therefore, to buy machines and to lay off people? If the machines are made in the USA, there may be an employment tradeoff; but if not, not.

Consumers do not have extra money to spend. By way of confirmation, a study reported in the October 10, 2011, New York Times finds that, since 2007, U.S. median family income has decreased about 10%. Even worse, if you look at the chart carefully, you can see that almost all of that decline has come since January 2009, a period of almost three years of near-zero interest rates. This suggests to me that businesses are right about the lack of consumer demand. And with many states cutting back on expenditures and Congress not in a mood to increase Federal expenditures, demand is unlikely to come from government.

Should we want consumers to borrow like crazy to boost aggregate demand? No, of course not. That is how we got here. And they will not do it, anyway, because, at least for the near term, consumers in general have learned the lesson of what happens when you borrow too much.

Therefore, no. I do not think “all that” is true.

Maybe it even is Harmful

Not only may the initial premise not be true. It also may be that low rates actually cause a great deal of long-term damage. Think about what low rates mean to people who are living on their savings. Think about what they mean to people who are trying to save for retirement. Think about what they mean for pension funds that assume a 7% return forever (or even higher). Think about what they mean for insurance companies that need investment income. And even, by gosh, think about what they mean to the social security trust fund that has $2.6 trillion dollars invested in U.S. government notes and bonds. (See Report of the Trustees.) What are the dislocations that will occur over the next 20 years as a consequence of these individuals and institutions not being able to earn enough to fund their needs? And what new bubbles are being blown?

Where should Interest Rates be?

I do not know what current interest rates—either long-term or short-term—should be. The market does not have an opportunity to speak because the Fed keeps on printing money and “twisting.” Maybe interest rates would stay just where they are: Low because the economy is not performing near its capacity and there is significant underemployment.

We got into this pickle in no small measure because the Fed kept interest rates too low from some time in 2003 through 2006 while consumers and the financial world levered up. Why should anyone think the Fed knows better now? Maybe they do, but based on past performance, they do not qualify for the Perfect Policy Hall of Fame.

I do understand that the people of the United States want someone in power to do something. But what if there is no short-term fix? If that is the case, as it appears to be, then why not focus on the medium- and long-term where good policy today could make a very positive difference tomorrow?

Implications for Investors

The Fed’s low-interest rate policy may move markets from time to time. But that policy is likely to make the long run worse. Congressional inaction on long-term imbalances also is not helping. People perceive that neither the Fed nor Congress is dealing with the real longer-term problems, such as Social Security, Medicare and global over-commitment. Therefore the period of public no-confidence is likely to continue, unemployment is likely to remain high (and underemployment worse), final demand is likely to remain slack, and corporate profits are unlikely to surge. Banks especially are likely to continue to have a hard time in the face of these economic realities. In this scenario, long-term stock investors may be wise to use ultra-short funds like the (ProShares UltraPro Short Russell 2000 ETF) SRTY and ProShares UltraPro Short S&P 500 ETF (SPXU) to hedge their long exposures, as well as to avoid companies that have high p.e. ratios on the basis that their earnings are projected to grow rapidly.

Source: Are Continued Low Interest Rates Good For The Economy?