Eric Von Berg - Newmark Realty Capital - 595 Market Street, Suite 2550, San Francisco, CA 94105 - for loan quote: 415 956 9922

August 11, 2011

The Fed promises to push our economy out of balance for two more years

The Board of Governors of the Federal Reserve issued a statement after meeting this week that the economic conditions are "likely to warrant exceptionally low levels for the federal funds rate at least through mid-2013".
A free-market economy is an ecosystem.
Natural balances are reached between buyers and sellers, landlord and tenants, debtors and lenders.  Nature's ecosystems that suffer a shock can heal themselves with time: so could our free market economy if left alone from government meddling.  History has shown that when governments distort the free-market balance through price controls or other means, bad things happen. Watch out for unintended consequences!

Wage controls during World War II helped create our dysfunctional employer-pay health care system.  Totalitarian states of the communist era were famous for price controls that backfired.  Communist Poland wanted to give its population cheap bread and did so.  Eventually farmers were feeding their pigs bread instead of raw grain: wasting the efforts of the miller, the baker, the truck driver, the retailer and the energy to bake the bread.

unnatural balance
The housing boom was caused to a large extent by the Fed reducing the Fed Funds rate to 1% following the blowup of the dot-com boom.  The Fed has kept the Fed Funds rate set in a range of zero to 0.25% since January of 2009 as a response to the bust of the Great Debt-Driven Boom (see Capitalwisdom, October 15th, 2010). Now they promise to keep interest rates artificially low for another two years. If an organism or ecosystem is artificially contorted for four years straight it will not spring back. Expect the unintended consequences to last for a while!

What the Fed is doing is a form of price controls.
Keeping interest rates artificially below their market-clearing levels is a form of “Financial Repression” (See this month’s excellent newsletter from William L. Gross of PIMCO.  This financial repression is a hidden tax on investors and savers. If you talk to a group of senior citizens you will hear the rage and despair that comes from this unfair tax on savers. The Fed is sacrificing our retirement savings to send profits to the banks.

At the Fed’s Board of Governors meetings there is one member who consistently votes against this policy of extremely low interest rates; Thomas Hoenig, President of the Federal Reserve Bank of Kansas City. Mr. Hoenig points out that these low rates are having the opposite effect to stimulating the economy. Banks historically strive to make a 3% net spread between their loan yields and their cost of funds. Banks can make this yield today without making new loans, by paying near 0% to their depositors in interest and buying 10-year T-Bills yielding around 3%. Since they do not need to reserve for losses and do not have the cost of a lending operation, almost all of the yield from T-Bills is riskless profit. The banks lock in profits
and improve their capital ratios – a no-brainer.

Banks getting addicted to buying T-Bills instead of making loans to businesses: This is like Polish pigs eating subsidized bread instead of grain!

As happened in the last period of artificially low interest rates, Mr. Hoenig fears unintended consequences this time as well. He points out that bubbles occur when markets are out of whack. Investors desperate for yield do desperate things. He says he cannot name all the bubbles occurring this time around but he can point to agriculture land in his district that has tripled in value. Though low interest rates have helped the banks, the opposite effects can occur. Banks that lend against skyrocketing asset values, like Midwest farm land, will get hurt when those values fall. The Fed is setting up the next boom and bust cycle. See the interview with Mr. Hoenig at the PlanetMoney web site.
Since cheap money is not working to revitalize the economy, why is the government so keen to put its weight on the borrower side of the financial scales?

It may just be related to the fact that Uncle Sam is the biggest debtor of all.

Heads-up... don't set up your business in a way that is dependent on these low interest rates. At some point level heads may prevail and the Fed will allow the free-market to work. If that happens interest rates will rise to a healthy level and our financial system can achieve a market balance.