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Why the Fed's Making a Big Mistake

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For years, the Federal Reserve has kept interest rates as low as they can go, as well as seeking out novel ways to juice monetary policy even further. In the short run, those moves have typically had their intended effect, boosting financial markets and preventing the wholesale deflation that plagued the economy during the Great Depression in the 1930s.

Few economists, however, would ever have expected that the Fed would keep rates this low as long as it has. Although policymakers obviously want to avoid the apparent folly of tightening monetary policy at a fragile turning point for the economy, there are a number of ways in which the long period of low interest rates has created disturbing trends -- trends that are proving to be more counterproductive than useful in guiding economic behavior going forward.

Time's running out
During ordinary times, lower interest rates drive economic growth by spurring investment. Because savings pay little and borrowing for new business projects is cheaper, companies have greater incentives to invest more. In effect, low rates set the bar lower for new investment opportunities to be successful, allowing companies to do some things that wouldn't have been profitable at higher interest rates.

But earlier this year, St. Louis Fed CEO James Bullard argued that although keeping rates low for short periods of time makes perfect sense, keeping them low over the long haul can have detrimental effects. Bullard gave examples of how savers got punished under such a policy. Yet even more important, he noted how the current economic environment, in which unemployment is high and lending standards are tougher to meet, has actually held people back from taking advantage of lower rates.

Lacking a sense of urgency
Other observations point to how the long period of low rates has arguably had a counterproductive impact on the economy. In housing, a number of factors have kept demand weak in recent years, including difficulty in getting mortgage loans and uncertainty about how long price declines may continue.

But one thing that is clearly holding potential buyers back is a lack of overall urgency. If you believe that mortgage rates will continue to fall, then it's silly to buy a home now when you'll be able to get it at an even lower overall cost by waiting.

By contrast, though, if the Fed threatened to raise rates, it would drive homebuyers to believe that they wouldn't get better conditions by waiting. Higher rates would make monthly mortgage payments more expensive even if prices stayed stable, and so those who have simply been waiting to try to get the best bargain possible would get driven off the sidelines in a buying spree. That in turn would help a host of companies, from Standard Pacific (NYSE: SPF  ) and its fellow homebuilders to home-improvement retailers and many affiliated businesses with ties to home construction.

Buying the wrong investments
Another way the Fed's low-rate policies are changing the economy is by influencing corporate policy on capital management. In particular, because traditional fixed-income investments haven't really produced much income lately, companies are under pressure to increase dividends even at the expense of giving up on potentially more profitable strategic moves.

Admittedly, companies have a mixed track record at best on squandering capital through takeover bids and share buybacks. But low rates have increasingly encouraged high-risk, cash-flow-producing investments like the leveraged mortgage bets that Annaly Capital (NYSE: NLY  ) and American Capital Agency (Nasdaq: AGNC  ) use. At the same time, as Apple (Nasdaq: AAPL  ) and Dell (Nasdaq: DELL  ) join the many companies that have recently initiated dividends, they represent the latest examples of businesses that can't find any more lucrative prospects for spending their cash other than returning it to shareholders.

Setting a finish line
At this point, just the idea of a possible end date to low rates might be enough to spur companies and individuals to get more active in taking economic risk. As long as decision-makers expect the Fed to give them all the time in the world before forcing their hands, the impetus toward greater economic activity from lower rates won't work nearly as well as policymakers would hope.

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Fool contributor Dan Caplinger has wrestled with falling rates for years. He doesn't own shares of the companies mentioned. You can follow him on Twitter @DanCaplinger. The Motley Fool owns shares of Annaly Capital and Apple. Motley Fool newsletter services have recommended buying shares of Apple and Annaly Capital, as well as creating a bull call spread position in Apple and writing naked calls on Standard Pacific. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Fool's disclosure policy never falls down on the job.


Read/Post Comments (12) | Recommend This Article (5)

Comments from our Foolish Readers

Help us keep this a respectfully Foolish area! This is a place for our readers to discuss, debate, and learn more about the Foolish investing topic you read about above. Help us keep it clean and safe. If you believe a comment is abusive or otherwise violates our Fool's Rules, please report it via the Report this Comment Report this Comment icon found on every comment.

  • Report this Comment On June 18, 2012, at 10:25 AM, lrob05055 wrote:

    Paul Krugman argues in his new book that a little inflation is just what the doctor ordered for many of the reasons you state in this article. But asking the Fed to raise rates without concurrently incentivizing growth with Keynesian spending seems to be only a half baked solution. What we really need is a fully realized plan for revitalizing this economy that inlcudes mortgage relief, substanbtial keynsian spending and fed inspired, and controlled, inflation.

    Not only will that make the real estate industry start to look attractive again, it will also have a salubrious effect on debt - both because inflation has the effect of reducing debt and because increased demand will increase the size of our tax receipts.

    The finger wagging Germans and Conservatives in this country are demonstrably wrong in their notion that austerity will provide us with any sort of solution to our current financial woes.

  • Report this Comment On June 18, 2012, at 11:40 AM, NeuroProf wrote:

    The Fed risks the loss of incentive for the masses because it has a much greater worry - keeping the cost of our national debt serviceable. If the Fed raises rates the US will soon require a bailout and that could pose a much greater problem. Some feel that inflation is inevitable, but maybe the Fed wants to see tax revenue increase enough to offset the higher cost of paying for our national debt at higher interest rates. We can't just print money forever - think of the backlash if Greece simply decided to circulate counterfeit Euros...

  • Report this Comment On June 18, 2012, at 11:52 AM, whyaduck1128 wrote:

    Why is the Fed making a big mistake? Because that's what they do. Make bad things worse, then proclaim that they're the only ones who can handle the situation they helped to create.

    Cynical, sad, but true. And we keep electing the fools (small f) who keep these"'bright boys" from "all the best schools", who associate only with those with the right connections, employed.

  • Report this Comment On June 18, 2012, at 11:56 AM, TMFMorgan wrote:

    <<then proclaim that they're the only ones who can handle the situation they helped to create.>>

    What Bernanke actually says:

    "Fed Chairman Ben Bernanke told lawmakers Thursday that the Fed alone can't put Americans back to work. 'I'd be much more comfortable if Congress would take some of this burden,' he said, bluntly."

  • Report this Comment On June 18, 2012, at 2:36 PM, TheRealRacc wrote:

    Austerity might not be the answer but Obama's definition of "investing" is far from productive or profitable.

  • Report this Comment On June 18, 2012, at 3:07 PM, BMFPitt wrote:

    Allowing rates to revert to even slightly less insane levels would allow the housing correction to be a little less slow. The last thing they want is for house prices to get too sane too fast. Their plan seems to be a long, drawn out pulling of the band-aid so that nominal prices flatline as inflation makes up the difference over 10-15 years.

  • Report this Comment On June 18, 2012, at 4:18 PM, TheDumbMoney wrote:

    Here is the Fed's job, Dan: maintain relatively stable prices, which they have long-defined as near-2% inflation. They are doing that.

    All the rest is either just confusing dicta spouted by an academic (Ben Bernanke) or the fevers of those who for various reasons like to focus only on that dicta.

    (Technically, the Fed is also supposed to promote full employment, but everyone knows that it is unable to do that, the Fed best of all. Hence, among other possible quotes, the one Mr. Housel highlights above in response to a typically misinformed commenter.)

  • Report this Comment On June 18, 2012, at 5:49 PM, StarWitchDoctor wrote:

    We are seeing the end game of the kenesian model.

    The assumption of perpetual growth has derailed us.

    As if we could not have seen it coming.

    The fed is still employing a faulty model. Prophecy says he will continue to do so until the end of his days.

    Have you the mark? Are you going to be found in the marketplace when the cycle (the 6000 year cycle) reboots?

    Scott

  • Report this Comment On June 18, 2012, at 5:52 PM, StarWitchDoctor wrote:

    add a y to kenesian

    scottY.

  • Report this Comment On June 18, 2012, at 9:05 PM, nffool wrote:

    My question DC is - What business outside of the banks (that can borrow at the Fed window) is really paying less than 1% for borrowed money? My experience is that the market decides what interest rate I get charged, not the Fed. Please send me the name and number of the institutions that are lending businesses at 1% interest short or long term.

  • Report this Comment On June 19, 2012, at 9:57 AM, TMFGalagan wrote:

    @nffool -

    I don't know about bank lending, but many non-bank issuers are getting rates of less than 1% direct from the bond market. Some examples:

    MCD 0.75% - http://www.fool.com/investing/general/2012/05/29/big-bond-is...

    IBM 1% - http://www.fool.com/investing/general/2012/02/06/new-records...

    It's pretty easy for a company to borrow at 1% if it has a good bond rating and wants short maturities of 3 years or so.

    best,

    dan (TMF Galagan)

  • Report this Comment On June 20, 2012, at 12:16 AM, nffool wrote:

    Thank you Dan for your response. I'm a little hesitant to buy into the " It's pretty easy" statement. Interestingly, I have always thought that small businesses with equity should be able to issue their own bonds - sounds like something a foolish lawyer could put together.

    Looking at the picture of investors buying three year bonds earning less than 1% or 10 year bonds earning 1%. I cant understand the motivation. (scared, lazy, ignorant, brilliant) I have high school dropouts on my payroll that bring me far greater than a 1% return. Interest rates are still market driven unfortunately small business is not in the right market.

    best est

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Dan Caplinger
TMFGalagan

Dan Caplinger has been a contract writer for the Motley Fool since 2006. As the Fool's Director of Investment Planning, Dan oversees much of the personal-finance and investment-planning content published daily on Fool.com. With a background as an estate-planning attorney and independent financial consultant, Dan's articles are based on more than 20 years of experience from all angles of the financial world.

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