How the Fed & Other Central Banks are Hurting the Economy & Banks

Somehow the Federal Reserve and central banks around the world have gotten it into their heads that the lower the interest rate the more it stimulates the economy and that if the economy is slower than desired, rates should be kept as low as possible for as long as necessary.

This is wrongheaded and some analysts are finally saying it. The effect only last so long until it becomes counter-productive.

The stimulative effect of low rates is to get people and companies to borrow to finance spending and expansion. But, when rates are close to zero banks cannot loan money profitably. The spread between a cost of funds at 3% and loaning it at 6% is profitable. The spread between the cost of funds at 0.5% and loaning it at 2% is not.

Since banks like to match maturities, if they make a 30-year mortgage loan they finance it with a 30-year treasury. But with mortgage rates at 3.6% and long term treasuries at 2.7%, by the time defaults and overhead are figured in, there is no profit left. In practice, a 30-year mortgage is paid off sooner, but even 15 and 20 year rates are too close to the mortgage rate now.

If banks can’t make a reasonable profit they don’t lend. If banks don’t lend, businesses, particularly small and mid-sized businesses can’t grow. That hurts the economy and bank profits as well.

Secondly, with the much tougher capital requirements and with central banks like the Fed paying interest to banks, banks are depositing their money with the Feds instead of loaning it out. This helps them meet capital requirements but money at the Fed is not money at work in the economy.

The idea of low rates is to get people to borrow to stimulate the economy but there is a point below where it becomes counter-productive. Thus, the Feds are contributing to the economic slowdown rather than helping it.

Third, when rates stay at crisis levels it hurts confidence in the economy.

The only thing being helped by this new game, which before the 2008 crisis had never been tried, is the government, which can borrow excessively with virtually no interest, at least for now. I shouldn’t need to point out that this is a bad thing, not a good thing. When debt is this high government stimulus from over-spending is ineffective.

Since entitlements alone are now equal to the entire stream of revenue the federal government gets, this money is all transfer payments to low income people, not the people and business that spend and expand. Those people and businesses are getting the double-whammy of tough credit and rapidly increasing regulation, not to mention the double-taxation on multinational companies at the highest rates of any developed country.

Thus, there are no winners from this game-playing with interest rates. Even though the stock market react negatively every time there is a hint of higher rates, the Feds should get it over with and get rates back up to somewhere in the normal range and they should do it immediately.