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

June 20, 2012

The Feds pledge: if at first you don’t succeed; keep making the same mistake.

Today the Fed Open Market Committee declared it would push the free market further out of balance.

Thanks to Fed actions and to problems in Europe, we are at historically low long-term interest rates; the yield on 10-year T-Bills is down to 1.64%. As if this is not enough, the FED pledged to extend the TWIST program using $267 billion over the next 6 months to exchange short term bonds for long-term bonds, to force long term interest rates still lower. The rationale? To stimulate the economy.

The Fed has used a horse-sized hypodermic full of monetary stimulus to get the economy up and moving, yet the US economy continues to lie still. So if that did not work, let’s give it another shot? Like the over-used quote from Einstein, “insanity is doing the same thing over and over again and expecting different results.”

Steroids hype short-term performance with bad long-term consequences. 

Shooting up the economic horse with low-rate steroids
The Fed policy of manipulating the free capital market with artificially low interest rates, may hype short term corporate borrowing, may save Banks from paying interest on deposits, deliver mortgages to those who can qualify, and even reduce the government deficit… in the long term it destroys the foundation of the investment sector; our pension funds, cities, retirees, insurance companies… it defeats the very motivation for long term investment.

The low-rate drug is not good for the economy; the side effects in the long-term are terrible; but the Fed keeps increasing the dose.

Besides the political pressure to “just do something!” what is the rationale behind this failed Fed policy?

The economic perspective of the Fed Board was shaped during the Carter-Reagan years, when interest rates were high, and lowering interest rates was an automatic, fast acting stimulus to the economy. Most of the stimulus came from two sectors; (1) the housing sector, and (2) corporate capital spending.

Now, despite years of low interest rates, the housing sector is still dead. So, let’s look at corporate capital spending.. In classic monetary policy; if you reduce the cost of corporate borrowing from say 10% to 8%, companies will start projects that return better than their 8% cost of capital, that were not justified at the10% rate. That’s the theory; but what also needs to be understood are the accompanying concepts of “payback-periods” and “corporate planning horizons”. A project that can return 10% per year has a 10-year payback period. If you are building a factory, a 10-year planning horizon makes sense.

But as the return decreases, the payback period increases.

Just like in the physical world, where physical properties change as temperatures approach absolute zero, so it is in the business world where as interest rates approach zero, normal business behavior changes. If corporate borrowing falls from a 3% cost of capital to 2%, the payback period for a project justified by these rates, increases from 33 to 50 years! This is beyond any corporate planning horizon. No company is going to make a 33-year bet let alone a 50-year bet.

The stimulus effect of the Fed’s manipulation of the capital markets peaked several hundred basis points ago. Shooting up the economic horse with more low-rate steroids, has gone beyond diminishing returns and is now only adding to the long-term negative side effects