Fed’s Zero Rate Policies Are Deflationary


Federal Reserve Chair Yellen feels stocks are fairly priced and is thus not worried about a bubble. This makes her feel free to stimulate the economy in an attempt to create jobs for the hidden long term discouraged unemployed. This is increasing stock market risks by making the bubble bigger and more volatile which can lead to a deflationary crash.

Low Fed Funds rates can act to stimulate the economy however the most likely outcome of low rates is that speculators will use borrowed money to speculate in stocks and real estate rather than to invest in a directly owned business.

When a business own contemplates expanding the business through the use of borrowed money what is far more important than the cost of money is the benefits that will be obtained by expanding the business. If adding new capacity will result in diminishing returns then even if the loan used to acquire more capacity is at zero percent interest the business manager will not accept the loan. Fed Funds rates don’t help to increase the activities of a business. A prudent business manager only borrows if he can verify that there will be adequate demand for a product and then only if the rate is fixed or has interest rate caps, etc. Fed funds can be changed suddenly, have no cap and have a precedent of costing 15% during the Volcker years in 1981.

What low Fed Funds do is they make it feasible for stock speculators to buy stocks and bonds with borrowed money so they can get the 2% dividend or 3% bond yield while paying 0.2% to borrow. These transactions are done because the buyer assumes he can instantly sell in a liquid market. By contrast other uses of borrowed money such as buying a car, a house, or a factory involve illiquid assets that may not be sellable for several years, especially if rates suddenly rose. 
Thus the main outcome of the Fed’s low rate policy has been to create a stock market bubble rather than to create an expansion of the physical economy.

Low interest rates can be deflationary because they intimidate moderate income retirees into feeling poor so they cut back on purchases and have a lower degree of consumer confidence. The result of the Fed’s Zero Interest Rate Policies “ZIRP” is that the most affluent people have used low margin lending rates to speculate and feel more prosperous while the moderate income people have become less prosperous. But the top 1% can’t spend as much as they make so this creates a deflationary “Savings Glut”, and meanwhile the rest of society may feel less prosperous. To make ZIRP work loans would need to be granted that are 30 year fixed to be used for business expansion or home buying but not allowed for speculative purchases.

Low fed funds rates can be used by margined borrowers to buy long term bonds which act to lower long term interest rates, however the invisible hand of the market can act out of fear that inflation will return and thus refuse to lower long term interest rates. Ironically if the Fed announced a withdrawal from short term ZIRP lending that would be seen be the market as a form of tightening that fights inflation which would act to lower long term bond rates.

Basically the Fed fools no one regarding interest rates because all players assume low rates are a temporary trick that will hurt them. The only exception to this are short term speculators who buy highly liquid securities in a gamble that they can sell before the crowd panics and tries to run through the fire escape when inflation returns. These gamblers not only put their own assets at risk but they risk hurting society because when a sudden dramatic crash comes then injured speculators may renege on other obligations that were not part of a margined trade. For example a speculator might be planning on living off of the proceeds of speculation and would instead have to cut back on consumption if he failed, thus hurting vendors who sell physical goods to him. A wounded speculator might have to renege on a home purchase contract, pull his kids out of private school, etc.

So the detriments of the Fed’s low short term rates outweigh the positives, partly because the asymmetric way they benefit mainly the rich and because they induce more risk which eventually results in damages to the economy. Some speculators will be adroit enough to exit a Fed induced bubble before the top but I fear the majority won’t, thus suffering from a crash and making society poorer off after the implementation of ZIRP.

Investors need independent financial advice about the dangers of stock market bubbles and crashes. I wrote an article “Fed press conference deflationary clues”.

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About the author

Don Martin, CFP®

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