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The Efficacy of the FOMC’s Zero Interest Rate Policy

Here’s a good essay from the St. Louis Fed, examining how effective ‘permanent zero’ rates are. As you know, I think permanent zero is toxic. Let’s see what the St. Louis Fed is saying though.

Since the late 1980s the Federal Open Market Committee (FOMC) has conducted monetary policy primarily by setting a target for the nominal overnight federal funds rate. In late 2008 the FOMC set the target at zero. It has since indicated that it expects the target to remain at zero until late 2014. Should this happen, the funds rate will have been zero for nearly six years. This essay suggests the possibility that the net effect of such a prolonged zero interest rate policy might be harmful for economic growth.

The so-called interest rate channel of policy works by adjusting the real rate of interest relative to what it would be if the FOMC did not increase or decrease its target for the funds rate. Reducing the funds rate target reduces real longer-term rates, which provides an incentive for businesses to increase capital investment, but only to the extent that the policy action reduces longer-term real rates.

The reduction in the real rate also affects consumer spending through what economists call income and substitution effects. The lower interest rate increases the price of future consumption, causing inpiduals to increase current consumption and reduce current saving—the substitution effect. The lower rate also reduces current interest income, which induces inpiduals to save more and consume less—the income effect. Consequently, consumption can increase or decrease depending on the relative magnitudes of the income and substitution effects.

That’s exactly what I have been telling you. When looking at GDP growth (from a flow perspective only), the question is whether the lower rate gooses credit growth enough to overcome the negative effects of lower interest income. What I have been saying is that credit growth effects don’t overcome lost interest income in a balance sheet recession. Just the opposite happens. Moreover, the stock variable effects of easy monetary policy in terms of increases in debt as a percentage of income or GDP have been quite negative over the past quarter century, as two economists from Deutsche Bank have recently detailed.

What about the indirect effects of permanent zero?

Persistently lower real rates can have an indirect effect on consumption because they induce individuals to take on riskier investments. Standard portfolio theory sees investors as balancing the risk of holding a particular set of assets against the average portfolio return. The desired portfolio is one that minimizes the risk for a given average return. Reducing the real rate of interest on bonds (especially low-risk bonds) relative to all other investments induces investors to hold riskier portfolios to increase the average return. Hence, in addition to the direct effect on current income, persistently low real interest rates might motivate individuals to save more in an attempt to compensate for lower expected future returns and higher risk. This effect is likely to intensify the longer real rates are abnormally low.

Two thing here: first, there is the savings effect that the St. Louis Fed has identified. Ultra easy monetary policy may induce savers to save more and therefore reduce consumption. That’s the perverse, even deflationary effect of easy money in a balance sheet recession. But then there are the distributional effects of altering private portfolio preferences. Investors are geared toward “riskier investments”. Translation: easy money creates malinvestment. When the Fed engages in financial repression to artificially suppress the price signal that interest rates represent, capital goes to riskier enterprises and projects. And when the risk-on trade turns to risk-off in recession, the losses are enormous. That’s what we saw during the TMT bubble in the late 1990s and what we saw again last decade with the housing bubble.

Bottom line: ultra-easy monetary policy has unintended consequences. Not only does it reallocate resources toward riskier investments, in a balance sheet recession, easy money may also induce savers to reduce consumption in order to increase savings, accelerating the very credit and demand deflation it is seeking to reverse.

When the Federal Reserve extends its zero rate policy to 2015 later this week, this essay is something to remember, especially if recession comes to the US despite the Fed’s efforts. It is during recession that the toxic effects of ultra-easy monetary policy are most clearly manifest.

Source: St. Louis Fed (h/t John Carney

About 

Edward Harrison is the founder of Credit Writedowns and a former career diplomat, investment banker and technology executive with over twenty years of business experience. He is also a regular economic and financial commentator on BBC World News, CNBC Television, Business News Network, CBC, Fox Television and RT Television. He speaks six languages and reads another five, skills he uses to provide a more global perspective. Edward holds an MBA in Finance from Columbia University and a BA in Economics from Dartmouth College. Edward also writes a premium financial newsletter. Sign up here for a free trial.

7 Comments

  1. Oldrich says:

    I have to say for me people like Draghi and Bernanke are almost heroes given the political environment they face and the way the issues are debated. When I see the Die Welt readers crowd in Germany or even more importantly the Tea Party and their level of discourse in the US it is really not difficult to pick where I stand on this.

    • David_Lazarus says:

      Yes the complete lack of fiscal action is one reason the Central banks are committed to this nuclear option. Though I do think that the overall policy is wrong. In the absence of fiscal actions to boost the economy they have no other option.

      The problem is that all this does is double down on mal-investment from the past. The next problem is how do central banks ever plan on normalising interest rates? Ultimately ZIRP is very deflationary as people have to over save to ensure that they have sufficient funds.

  2. draines says:

    The real reason that interest rates are low is so the government can continue to borrow at low rates. No one ever talks about the fact that they can not let rates rise beacuse of the interest PAYMENTS on the deficit. we paid over 400 Billion in intetest last year. We brought just over 2.1 trillion. Do the math if interest rates rise 1 or 2 percent from current rates and the same tax revenues are the same. Can fund the deficit which is why the fed will be the buyer of last resort of the treasury market! Not good people.

  3. draines says:


    The real reason that interest rates are low is so the government can continue to borrow at low rates. No one ever talks about the fact that they cannot let rates rise beacuse of the interest PAYMENTS on the deficit. we paid over 400 Billion in interest last year. We collected just over 2.1 trillion in taxes.Do the math if interest rates rise 1 or 2 percent from current rates and the same tax revenues are the same. This is before medicare and defense. We cannot fund the deficit which is why the fed will be the buyer of last resort of the treasury market! Not good people

    • Well, that is the original reason that I dubbed this policy ‘permanent zero’ instead of just zero interest rate policy.

      See here:
      http://www.creditwritedowns.com/2011/08/permanent-zero-toxic.html

      “Remember, Japanese government debt to GDP is 200%. It’s not like the Bank of Japan would actually want to raise rates. As I wrote in March:
      Japan’s long-term rates reflect private portfolio preferences as determined by expected future interest rates… So 10-year rates are low because expected inflation and expected future short-term rates are low.Japan’s Debt to GDP is over 200%, meaning that any uptick in expected future short-term rates due to inflation would be disastrous in terms of interest due.So, to avoid this scenario, Japan must leave short-term interest rates at near zero percent or risk the crowding out of public spending that higher interest payments would entail. Only if the debt to GDP ratio declines significantly can it relax this stance.”

      • draines says:

        Excellent point. Not to many people seam to get that. They will continue to destroy the dollar. Every single fiat has gone bust, the dollar will be no different. It. Will have lasted the longest though.

  4. Pacioli says:

    “When the Fed engages in financial repression to artificially suppress the price signal that interest rates represent…”

    But what if the ‘natural’ rate of interest is actually BELOW, not above, where they are now due to ‘Fed interference’.

    http://on.ft.com/TvKk4e