Our nation's interest rate problem

Banks stuck with troubled real-estate-related loans. An economy in the doldrums with high unemployment. No, that isn't a snapshot of today's economy. It is what the United States looked like 30 years ago, as it emerged from the recession of 1980
AUG 21, 2011
By  MFXFeeder
Banks stuck with troubled real-estate-related loans. An economy in the doldrums with high unemployment. No, that isn't a snapshot of today's economy. It is what the United States looked like 30 years ago, as it emerged from the recession of 1980. Today, the economic situation appears similar except for one significant area — monetary policy. Thirty years ago, the federal funds rate was 20%. Today, the rate is about 0.1% and the Federal Reserve intends to maintain the rate, at which banks lend from Fed balances to one another overnight, below 0.25% until 2013. The prime rate — what banks charge their best customers — was also in the double digits 30 years ago, rising to 21.5% in June 1982. Today, the prime rate stands at 3.25%. From an environment in which interest rates seemed unnaturally and frighteningly high, we are now in a world where interest rates seem unnaturally and frighteningly low. Then, under Chairman Paul Volcker, the Fed's policy was to shrink the money supply, raise interest rates and choke inflationary expectations. The policy worked, ushering in a decades-long bull market for bonds, in which interest rates kept going lower. Today, under Chairman Ben S. Bernanke, the Federal Reserve is intent on supplying the anemic economy with as much liquidity as possible. A student of the Great Depression and fearful of deflation, he would rather err on the side of too much liquidity than too little, certain that whatever inflationary mess the Fed might be required to mop up later would be far less painful than having the economy deflate now. For the sake of all of us, let's hope that Mr. Bernanke's prescription turns out to be right. In the meantime, however, the Fed's program is producing its own economic distortions and pain. For one, large corporations and banks are awash with cash, yet little of it is being put to use. Giant companies, which now hold $963 billion in cash, according to Standard & Poor's, are neither hiring nor investing to any great degree. Commercial-bank deposits stand at almost $7.4 trillion, yet smaller businesses say they have a hard time securing loans. The transmission mechanism that is the nation's banking system — in effect, the financial gearbox that sits between the money-creating engine of the Fed and the drive wheels of business — is clearly slipping. Thomas Hoenig, the outspoken president of the Federal Reserve Bank of Kansas City, has criticized the central bank's near-zero interest rate policy, saying that it unfairly subsidizes large banks at the expense of savers. He makes a valid point.

SAVERS ARE STRANDED

Millions of middle-class and affluent savers and investors are seeing the purchasing power of their retirement nest eggs wither as even today's modest inflation rate exceeds the minuscule returns on safe Treasury securities and bank-insured deposits. For financial advisers, there are no easy solutions to recommend. Taking on more risk may be appropriate for some investors but probably not for those battered by the most recent downturn and those near or in retirement. For some, dividend-paying stocks may work. For others bonds of high-quality companies may provide slightly higher returns. The best course for now simply may be to keep one's powder dry and secure for the future. If the Fed's vigorous monetary easing turns out to be the futile “pushing on a string” effort that worried economist John Maynard Keynes, we all will want to have a cushion for the hard economic times that may well ensue.

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