We must break addiction to low interest rates

  • By James McCusker
  • Thursday, September 24, 2015 12:09pm
  • Business

The Federal Reserve is in a quandary. It wants to raise interest rates but last week, facing global market instabilities, it wisely chose not to act. Instead it was “steady as she goes,” leaving interest rates and policy direction unchanged. Of course it also prolonged the quandary, and left many wondering how it would be resolved.

The Fed’s decision was a compromise with market reality and that is not usually a bad choice. In this case, though, it does raise questions of when the time will be right to begin bringing interest rates back to normal.

We can certainly sympathize with the Fed, which is dealing with extremely twitchy markets both here and abroad. It was going to be judged wrong no matter what it decided to do. The exaggerated sensitivity of Wall Street to a proposed quarter-point increase in the interest rate is partly the result of the secular rise in price of U.S. Treasury bonds over the past 30 years. The Fed’s near-zero interest rate policy has been good to the bond market and any change in that policy would mean significant losses for bond holders. No amount of data or explanations of how the decision would alter that loss or reduce its sting.

The Wall Street turmoil that followed the Fed’s decision last week was quickly called a tantrum — presumably to honor the memory of the notorious “Taper Tantrum” of 2013. The financial markets threw a near-hysterical fit when the Federal Reserve said it would gradually reduce its Treasury bond-purchasing program.

In the current situation, market analysts claimed to be puzzled less by the Fed’s decision than by the explanation that accompanied it. If the bank were so worried about the economic slowdowns in China and Europe that it postponed its monetary policy move, for example, what does that say about the prospects for the U.S. economy?

In its press release the Federal Reserve described the financial markets as “unsettled,” but this is an understatement. What would be more accurate is that the U. S. market is clearly addicted to near-zero interest rates and at this point cannot really even think rationally about life in a world which included the true cost of borrowing.

From a market behavior standpoint it is interesting that the Taper Tantrum occurred before the Fed actually did anything. It was set off by the central bank’s merely saying that it would gradually reduce its bond-buying. That kind of volatility was clearly a symptom of addiction-driven behavior that is unsurprising, given that the Fed’s interest rate policy has not changed substantially for almost seven years.

The Federal Reserve has promised to answer all the questions raised over its most recent decision to stand pat on rates, but it is unlikely to be able to do so in a way that will satisfy the questioners. What market analysts and investors are looking for is certainty, and no amount of transparency about policy decision-making can provide it to them.

The Fed’s quandary is that it wants to begin gradually raising interest rates — for two solid reasons. The first is that the zero-rate environment takes away its most direct and effective monetary policy tool to counter an economic slowdown. It cannot really lower interest rates if they are already zero. Even the most skilled craftsman needs tools to be effective, and the Fed’s tool box is nearly empty.

The second reason is that it usually takes months before the full effects of a monetary policy change are felt throughout the economy. A wise central bank, then, tries to anticipate inflationary pressures and time a gradual upward change in rates so that the economy cools down just enough to keep prices stable…without snuffing out the recovery. A twitchy market, of course, gets in the way of this orderly progression and reacts, or overreacts, immediately, producing the Fed’s quandary.

There could have been a third reason, but it is not based on existing Federal Reserve policy — because at this stage it more of a concern and an instinct in some quarters than a vetted theory. It would be that the U.S. economy’s growth is so lethargic because of the imbalance caused by artificially low interest rates that disrupt the relationship between savings and investment. Like an unbalanced ship that is listing to one side, for example, our economy can still move forward under its own power, but not at full speed.

Our economy has been operating under artificially induced interest rates for seven years now, longer than any similar period in our monetary policy experience. The zero-rate prescription cured the financial crisis but left financial markets addicted and the unbalanced economy trying to adapt. It’s time for a change.

James McCusker is a Bothell economist, educator and consultant. He also writes a column for the monthly Herald Business Journal.

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