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The Federal Reserve Board recently announced its plan to keep short term interest rates between 0 and 0.25% until 2014. Rates are essentially zero for already four years.

Under normal circumstances cheaper credit would result in increased demand for loans for businesses, consumers and the government. However already overlevered consumers, states and the federal government have adopted austerity measures and businesses consequently will not invest. In today's financial reality lowering the cost of borrowing does not spur demand, yet it does have a range of other nasty consequences across the economy.

Let's run through all the unintended consequences of such monetary policy.

Banking Subsidy

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. Net interest margins for the sector came in around 3.5% in 2011. While these margins are not extremely high on a historical basis a lot of these funds are immediately invested back into Treasury bonds, allowing the financial sector to maintain the value of its loan book. Furthermore the quality of the loan book has improved as the US Treasury has become a more prominent creditor on the banks balance sheet.

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 built up reserves again. This has essentially been a huge subsidy in disguise.

Lack Of Fiscal Discipline

The record low interest rates, fuelled by the Federal Reserve's purchases of government debt, have not put too much constrain on the discipline of the government finances. In 2011 the government ran a deficit of $1.27 trillion as total public debt rose to an astonishing $15 trillion. In 2011 the government's total interest expense added up to $454 billion which is a really high amount, but would have been much higher if rates remained at their levels in 2006. If rates were up 2% across the board the government would have to spend $300 billion more in interest payment which would benefit "prudent" savers and require the government to become more "disciplined" about its finances.

Suffering Retirees

Retirees, those who completely depend on investment income rather than labor income, are hurt pretty badly. Those who lived on dividends have done largely alright but interest income has been falling significantly. The Bureau of Economic Analysis estimated that total interest income for all American's has fallen from $1.38 trillion in 2008 to just $1.01 trillion in 2010. These people can not compensate their income gap by temporarily borrowing or work again in many instances.

The 1% that many certificates of deposits are yielding at the moment fail to compensate for inflation currently running at around 2.3% per annum according to official release figures.

Attract Speculation

With nominal interest rates near 0 many investors and speculators are hunting for additional yield, often switching investments for a couple of basis points yield more return. With funding costs near zero for the US dollar it has in particular channeled a lot of funds to the so-called carry trade, where investors buy currencies which pay a higher rate of interest such as the Canadian Dollar, New Zealand Dollar or the Australian Dollar while selling the low interest rate currency. These kind of strategies have grown enormously in size in recent years.

Reinvestment risk

Financial institutions have to increase their spread, the rate at which they lend the money to the public vs. the cost at which they obtain funding, as rates approach zero. The nature of the lending of banks is often long term, while funding is typically shorter term based. As such banks face significant risks by lending out money at very long periods (such as a 30 year home mortgage) while only obtaining low single digit nominal interest rates. If rates were to rise significantly during the term of the loan banks could see their holdings become progressively worth less.

Inflation

During the crisis the US economy has seen a brief period of deflation in 2009 as the economy was running of a cliff, something which spurred the Federal Reserve Board into aggressively lowering the Federal funds rate in order to avoid a deflation scenario. Inflation has picked up pace recently now around 2.5% per annum indicating that the Federal Reserve has set real interest rates at around -2.0% something which adds an annual "tax" of 2.0% on saving and investments and an equivalent subsidy on borrowing.

No borrowing

Despite the fact that borrowing has been made artificially attractive by the monetary tools, consumers are not borrowing. Mortgage debt of consumers has fallen by $1 trillion to $13.5 trillion during the last five years while total consumer debt remained stable around $2.5 trillion. Weak confidence in future economic growth, high youth unemployment and tighter borrowing constraints limit demand for growth. Even as interest rates and asset prices go down (including home prices) demand from consumers remains subdued.

Pension funds

Pension funds across the board have become more and more underfunded. A triple whammy of a higher life expectancy, lower discount rates and lower asset returns resulted in a deadly cocktail which led to trillions in underfunded pension funds across the country. Many funds have assumed a 8% rate of return on their assets which they have not realized for many years in a row. Many funds, even larger ones, are approaching funding rates of a mere 50%. Years of no indexation for inflation, outright cuts is benefits, higher pension premiums and an increase in retirement age are all needed in order to contain the problem.

Reward bad behavior

Worst is that the financial sector and reckless consumers who took out home equity loans and swiped their credit cards are effectively getting bailed out, as they see their interest rates stabilize at lower rates. Those companies and consumers who behaved in a prudent manner are now getting hurt for many years in a row with negative real interest rates. As such the Federal Reserve has left prudent savers and retirees out in the dark. The monetary policy of the Federal Reserve has been used as a re-distribution tool on top of fiscal policy, rewarding those who behaved reckless while penalizing the prudent market participants.

Time to raise rates

The Federal Reserve's policy is hurting too many participants in the financial markets, and worse of all it is hurting those who behaved in a prudent manner in recent years while rewarding those "reckless" participants. It is time to raise rates to a level where there are no longer negative real interest rates, in order to restore "moral" responsibility in the markets.

Source: The Fed's Policy Of Low Interest Rates Is Hurting The Economy