George S. May Business Blog

Fed’s Zero Percent Interest Rates May Cause Problems

The Federal Reserve’s traditional role of setting the interest rate has been admittedly easy since they set the rate at 0%. The low, low rate of zero percent is known as the Zero Interest Rate Policy or ZIRP for those of you given to funny sounding acronyms.

The Fed’s chairman Ben Bernacke has repeatedly said these record low interest rates are vital until the economy gets back on its feet, and that these rates will be instrumental in accelerating the economy out of troubled waters.

Bernacke has pledged to continue the same policy of ZIRP for what he has called an extended period. Since December of 2008 the Fed has tried to keep the interest rate between 0% and 0.25%.

This range was thought necessary to lure investors out of their shells after the vitriolic market allowed to risks run rampant as profits disappeared from coffers. This rate should theoretically spur lending significantly, at this point the emphasis is still firmly on the word “theoretically”.

The assumption behind high interest rates following a fiscal downturn is that it will keep people from putting money into the market or purchases of homes and cars, which would then unhopefully lead to a further slide down into what economists refer to as the misleadingly delicious sounding double-dip recession.

Well however misleading many of the names of the key elements of the Fed’s plan may sound, so far many people believe it to be a necessary evil of the recovery process.

However this policy also means that investors are once again privy to large sums of money at wonderfully favorable rates, which leads many to believe that this move could actually lead to a worsening of the recession if left unmonitored.

A ZIRP could also be a terrible thing at a time in which it seems many larger investors and companies have trouble when it comes to assessing the risks of the investments they make. Giving people the access to money at such low interest rates may cause more careless deals that were seen in the more recent crisis. But over-lending and the subsequent problems of lending vast sums of money when there is a possibility of failure could lead to the kind of stock free for all that aided the collapse of the market back in 1929.

While Chairman Bernanke said he would raise rates once the economy was back on its feet, he did little to calm the growing fear that that Zero Interest Rate Policy is feeding another speculative asset bubble.

Kansas City Federal Reserve Bank President Thomas Hoenig was not so circumspect. Hoenig said that an extended period of ultra-low interest rates invites speculative behavior. “When you have zero rates that go on indefinitely, you are inviting future problems,” he said. Speculation bubbles are often the cause for tanking an economy as they burst.

Hoenig is not alone in his sentiment that ZIRP encourages risky financial speculation in a number of ways, and as a result, many observers believe it is actually a highly dangerous and potentially destructive policy.

There are many reasons that those educated in the way of money are against ZIRP, here are just a few of the more prominent concerns:

When savings accounts and certificates of deposit earn essentially zero, then everyone from mutual fund managers to households is forced to look elsewhere for a return on their capital, and these elsewheres invariably involve higher risk to achieve similar gains.

This also reduces the cash deposited at banks, ironically sapping their ability to lend. Higher interest rates — in the Fed’s view, a terrible, frightening prospect — would actually draw cash into banks, which desperately need to bolster their cash reserves in order to lend money to creditworthy businesses and homeowners.

Traditionally vital institutions such as savings accounts and banks are both in serious danger when a ZIRP is enacted. A highly influential financial information firm even took the situation so far as to say, “When the Fed embraces a zero rate policy, what they are telling investors is that bonds and other rate-sensitive financial assets have no value.”

Short-term moves are usually done out of desperation in the first place, but leaving these desperation tactics in place could lead to serious trouble. Let’s hope Ben Bernacke agrees.

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