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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