Monday, July 23, 2012

The Low Interest Rate Conundrum (July 19, 2012)

The Low Interest Rate Conundrum
Michael D. Lavespere
July 19, 2012

Article Review:   
Bernanke, B. (2012). Semiannual Monetary Policy Report to the Congress. Board of Governors of the Federal Reserve System. Retrieved from http://www.federalreserve.gov/newsevents/testimony/bernanke20120717a.htm
Abstract
The purpose of this analysis is to scrutinize the cost—directly or indirectly—to corporation, employees, and consumers due to the maintaining of near-zero Federal Funds Rate upheld by the Federal Reserve System on July 17, 2012.  In addition, the research will demonstrate that a low-interest rate can cause unintended consequences that slow economic growth if held too long.  The purpose for adjustments in the Federal Funds Rate, explanations for a slow recovery of the economy, and corporate employee relations is discussed.
Keywords:  FBR, Bernanke, Federal Funds Rate, Bush Tax Cuts, Affordable Care Act

 

Introduction
On July 17, 2012, Federal Reserve Chairman Ben Bernanke delivered his twice-a-year projections for the U.S. economy to Congress.  As many anticipated his speech on what the Federal Reserve Board may, or more importantly not do to help the economy, the message was disappointingly clear that the Federal Reserve Board has little options left to stimulate the economy.  Bernanke’s assessment was less than optimistic calling for help from a Congress that seems to agree on very little pertaining to stimulating the economy.  During the 1990’s, one would expect, then Chairman Alan Greenspan to either raise or lower interest rates to navigate the economy towards established monetary policies and indicators.  After such, some noticeable change would be apparently noticed nearly a year later.  However, fast forward to 2012, interest rates are at an all-time low and the intended effects are not working.  Thus, additional rate reductions would only seem to harm an already paradoxical market or at minimum have no positive outcome.  Equally important, it appears Bernanke has nothing more to give but to challenge Congress for a congressional agreement for extending tax cuts and spending cuts by the end of the year.  In 2007, during his bi-annual meeting with Congress, Bernanke stated, “overall, the U.S. economy appears likely to expand at a moderate pace over the second half of 2007 with growth then strengthening a bit in 2008 to a rate close to the economy’s underlying trend” (Wessel, 2012).  Five months later in December of 2007, the recession began.

Methods Results and Conclusions

The Intentions of Lower Rates

There are several reasons why the Federal Government is inclined to lower interest rates.  Most common is to curb inflation to ensure price stability; moreover, high unemployment, economic growth, business and consumer spending indicators are equally as important in determining needed adjustments.  When the Federal Government lowers interest rates, they are essentially setting the federal funds rate as a standard for banks.  As a result, the rate that banks lend and borrow money to each other also decreases.  This decrease in the federal funds rate is extended to businesses and consumers through tradition loans.  With lower interest rates, consumers and businesses are encouraged from an economic position to borrow money to spend, invest, growth, etc.—at least in theory.  This spending facilitates the mutually inclusive growth relationship between spending, unemployment and economic growth.  Once the upward direction is achieved, a rise in interest rates will slow the spending and growth to a nominal level to thwart inflation.

The Slow Economy

After the 2008 recession, unemployment began to soar and spending by businesses and consumers dropped dramatically.  As expected, Bernanke began to lower the federal funds rate throughout 2008 for a bottom-out of 0.25% in January of 2009, where it still stands today (FRB, 2012).  With a historically low cost of 3% over prime interest rate extended to consumers and businesses, one would expect a surge in borrowing, spending and economic growth.  Conversely, with 43 months of near-zero borrowing power, the market is not responding as expected.  Consumers and businesses are not borrowing and the economy is not growing as expected. 
Many “talking heads” argue that the European financial crisis and the presidential campaigns are the causes for the unexpected inverse reaction to low interest rates and the slow growth of the economy.  Although the European financial concerns and the pending elections are noteworthy, they are just simply too small of a factor compared to the real problem.  The fundamental problem is that consumer spending is still down and understandably so.
         The economy is a speculation game and perception is reality in most cases.  Although businesses are mostly recording favorable profits, the apprehension to leverage debt to expand stems from uncertainty around the impact of the Affordable Care Act (2010) and the Bush Tax Cuts (2003).  The Affordable Care Act has most businesses—especially small businesses—concerned on how it will influence the bottom line.  According to the U.S. Small Business Administration, small businesses employ half of the private sector and have historically generated 65% percent of net new jobs (2009).  This major employer of the economy is not expanding and has chosen to utilize current assets (money, people, etc.) to its full capacity.  With no new hires on the horizon until the uncertainty clears, the unemployment rate will remain high.  Moreover, since businesses are not expanding, they are not borrowing money.  Whether interest rates are low or high does not matter if no one is borrowing money.  In addition to the Affordable Care Act, the Bush Tax Cuts—formally known as the Jobs and Growth Tax Relief Reconciliation Act of 2003 (JGTRRA)—are scheduled to expire at the end of 2012.  If Congress does not extend the Act, small businesses will see the reversal of tax cuts and deductions that they have enjoyed for years.  With uncertainty around future increases in taxes and healthcare costs, businesses are reluctant to expand by borrowing money and hiring employees.

Corporate Leverage over Employees

Regrettably, many corporations have used the uncertainty of the economy and high unemployment rate to their benefit to maximize profits and reducing cost.  Employees are tasked to do more with less, fill attrition with over-time hours, and work harder in fear of losing their jobs.  With an 8.2% unemployment rate, corporations can easily find labor to fill such demands.  Regardless of the disposable income, the anxiety of being the next victim in layoffs is a constant threat to employees.  With this fear, consumers are not readily approaching banks for loans—regardless of low interest rates.  Mortgage and debt loans are long-term commitments that borrowers are not willing to acquire with very little job security.  Many consumers’ debt and credit limit is still relatively high from years of over spending, mortgage values are still low and their savings are running thin.  The underlining conscience from consumers with disposable income is to pay off debt faster with the lower interest rates and make less expenditure until market confidence is restored. 

The Frugal Shall Be Punished

The hardest hit consumers of low interest rates are those who have maintained personal fiscal responsibility over the years.  This is especially the case for senior citizens who are feeling the deleterious effects of low interest rates on fixed-income investments like certificate of deposits (CD) and bonds.  For example, according to Bankrate.com, the national average of a 1 year CD return is .31% and “that same CD five years ago was near 6%” (Campbell, 2011).  Additionally, those that have saved over the years are not impervious to the effects of low rates.  The average annual percentage yield on savings accounts is 0.20% in the first quarter of 2012 (Barrington, 2012).  Individuals who have been the most monetarily responsible are forced into riskier investments for the needed income.

The Chasing Yield Affect

If the lack of economic stimulus from the low interest rates and shrinking fixed-income investments are not concerning enough, consider a new threat that appears to be on the rise.  In May of 2012, JPMorgan Chase acknowledged a $2.7 billion trading loss in investments.  Regardless of the ethical critics around proprietary trading, the root problem is that market yield on investments are too low.  As with investors, banks are also forced in seeking more risky investment to offset the low yields.  This form of hedging is quite acceptable in the airline industry who often hedges fuel to offset rising prices.  Before vilifying CEO Jamie Dimon and JPMorgan Chase, one must consider the alternatives.  Banks have little incentive to seek dicey borrowers for low yields when the federal funds rate is near zero.  Such a low cost of cash should be invested in other areas with higher yields and less risk.

Conclusion

            The anticipated and intended reasons for low interest rates were to encourage consumers and businesses to borrow and thus spend.  However, the effects have been quite the opposite due to the long term near-zero rates.  All potential stimuli have most likely been extracted from the market within the first year of such low rates.  Chairman Bernanke’s plea for Congress to address the pending tax increases if the Jobs and Growth Tax Relief Reconciliation Act of 2003 is not upheld is sound advice.  Congress should further consider not only extending the tax cuts but also shelving the Affordable Care Act until certain economic indicators are met.
References
Barrington, R. (2012). Best Rates for Savings & Deposits in the US. Retrieved from     http://www.money-rates.com/research-center/americas-best-rates
Bernanke, B. (2012). Semiannual Monetary Policy Report to the Congress. Board of Governors of the Federal Reserve System. Retrieved from http://www.federalreserve.gov /newsevents/testimony/bernanke20120717a.htm
Board of Governors of the Federal Reserve System. (2012). Interest Rates Paid on Required Reserve Balances. Retrieved from http://www.federalreserve.gov /monetarypolicy/reqresbalances.htm
Campbell, K. (2011). 3 High-Yielding Fixed-Income Investments. Retrieved from http://money.usnews.com/money/blogs/the-smarter-mutual-fund-investor/2011/09/21/3-high-yielding-fixed-income-investments
Wessel, D. (2012). Oops: What Bernanke Said Five Years Ago Today. The Wall Street Journal. Retrieved from http://blogs.wsj.com/economics/2012/07/18/oops-what-bernanke-said-five-years-ago-today/

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