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The Federal Reserve’s Risky Policies

Posted by Steve Markowitz on December 17, 2012

Last week Federal Reserve Chairman Ben Bernanke made two significant announcements concerning additional aggressive Federal Reserve (Fed) actions.  First, the Fed will continue to keep interest rates at near zero until the US unemployment goes below the targeted rate of 6.5%.  In addition, the Fed will increase its quantitative easing (QA) to $85 billion per month, nearly double the current rate.  With QA the central bank buys America’s debt in an effort to drive down interest rates and stimulate economic activity.

If history is a reasonable judge, the recent steps by the Fed are doomed to fail.  A super-low interest rate policy has been in place for four years.  Given the policy’s failure to stimulate the economy during this lengthy period makes it unreasonable to expect much benefit from it going forward.

While low-interest rates can stimulate the economy, this will not occur when the problem is liquidity based.  The ongoing economic downturn was caused by excess debt that needs to be de-leveraged before real economic growth can begin.  As a result, much of the low-interest loans are not being invested in areas that lead to economic growth, but instead are being taken by corporations as a source of low-cost long-term funding.

There are negative consequences for economic growth from the low interest rates, particularly for people on fixed incomes including the elderly who have seen their incomes drop significantly.  In addition, pension funds’ returns are artificially low requiring companies and municipal governments to fund them in lieu of spending funds on productive projects that could lead to long-term economic growth.

When the Fed’s low-interest rate policies began in the latter part of 2008 the concern was whether the Fed would be able to withdraw the funds from the economy quick enough to avoid rampant inflation.  Many economists at the time suggested that this would need to occur within a 16 month period.  As the chart shows, now four years later, the Fed’s priming the pump continues with no end in sight.

As serious as the failure of the Fed’s policy is, the real danger for the economy is that it may someday succeed.  When the employment rate approaches the 6.5% target, the fear will be that the Fed will start increasing interest rates.  This will suppress economic activity, especially for an economy that for years has gotten his direction based on Fed interest rate policies.

Another concern is that the Fed’s policy will lead to investors making imprudent investment decisions leading to significant asset bubble creation.  As with all bubbles, they ultimately must pop leading to widespread economic crises.  Less than five years after the pop of the housing bubble that was in part caused by the Federal Reserve’s earlier low interest policies, it is evident that the Fed has learned little from that painful lesson.

Fed Balance Sheet

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