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Tuesday, 15 September 2015 09:10

Risks of continuing Fed’s zero rate policy

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Hiking interest rate has its own risks, but even if Fed does not raises rates, it faces a number of risks. A brief study is given below –

  1. A failed policy should not be continued – ZIRP (zero interest rate policy) was meant to stimulate economy by providing easy money. It was supposed to boost credit growth that has not taken place.
  2. A flawed concept – At near zero rates, loan seekers would take loans but why would a bank give loans? Especially when risks are still perceived in economy and there is a threat of rates rising (even if in distant future). Banks may loan only for short term.
  3. Fuelled asset bubbles and imbalances in asset allocation – Over six years of Fed’s lower rates, QE, and forward guidance (of keeping rates low for a long term) caused a surge in risk assets. When the banks offer near zero returns on deposits then who would put money in banks? In order to get higher returns people started looking for other investment options, mostly all were risky. ZIRP forced even conservative investors to take risks especially with its forward guidance. Households as well as institutions avoided safe deposits and opted for riskier assets. Intended investments have not taken place and unintended speculation is on rise.

Where the money went –

  • Stocks
  • Junk bonds and high yield bonds
  • Private equity
  • US auto loans
  • Shale oil and gas
  • Buybacks and M&A
  • In Europe the banks bought their own risk free bonds
  • In China, property bubble and loss making SOEs

Where the money didn’t go –

  • Higher wages
  • Infrastructure
  • Industries

Problem with central banks is that they can provide easy money but are not able to control its allocation. Even IMF has now recommended that there should be more control over where banks can and cannot lend. It has taken very long for the IMF to find that it cannot control allocation of resources. Instead of imposing more controls by central banks, it should think about free market interest rates.

  1. Heavy losses by households and pension funds – During 2007-12 households lost 360 billion USD in interest income due to low interest rates. Pension funds lost bigger amount.
  2. Lower spending by households – Lower interest income is a big setback especially to older people, as they save more for their retirement and are dependent on interest income. When their interest income falls they spend less and work more. That also leads to fewer jobs for younger people.
  3. Contagion effect in Emerging Markets – Very low interest rates are exported to EM via carry trade and leads to asset bubbles and contagion effect. At low rates banks and corporate sectors are encouraged in carry trade – borrowing from Fed at near zero rates and investing in other countries where rates are higher. It is a no-loss game for US organizations. The loser is the US economy, as the money leaks to other countries (mainly EM), out of US where it was supposed to promote growth.
  4. Changes in human behavior – Sustained low interest rates affect human behavior for the worse. Due to falling interest rate income, saving is discouraged and thrift becomes a relic of past. Buying on credit will become a second nature of people. Consumption is increasingly financed with credit instead of by savings. Culture of credit card and instant gratification will take centre-stage. Without savings and with rising debt, wealth creation increasingly looks a distant dream.
  5. People have no motivation for fiscal discipline.
  6. Banks NPAs are hidden – Low rates enable banks to rollover their non performing assets indefinitely and thus hide their true health. In absence of ZIRP, weaker banks may get destroyed but that would be a healthy deleveraging.

ZIRP failed totally in achieving its aims, fuelled speculation and asset bubbles, created imbalances in economy, and if it is allowed to continue, the risks from asset bubbles will become unmanageable.

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