Thursday, December 20, 2012

Zero Interest Rates are the Problem

From the ever wise Andy Kessler:

In a "beatings will continue until morale improves" announcement, the Federal Open Market Committee, on September 13, declared, "If the outlook for the labor market does not improve substantially, the Committee will continue its purchases of agency mortgage-backed securities, undertake additional asset purchases, and employ its other policy tools as appropriate until such improvement is achieved in a context of price stability."
But maybe, just maybe, ZIRP is the problem, not the solution. Money is not stupid. Corporations are sitting on almost $2 trillion in cash. The humps in strategic planning or business development at every Fortune 500 company run spreadsheets that forecast the return potential of new projects or factories and compare that against the cost of capital or the risk-free rate of return before pitching said projects to upper management. But because of ZIRP, the risk-free rate of return is zero, so, in Excel anyway, it looks like every project or factory makes financial sense. But that can't be right. This is what causes uncertainty, a financial compass that spins round and round rather than pointing to value creation. Which means managers sit on their hands. So in the real world, none of the projects makes sense. In other words, the very Fed policy aimed at growing the economy and creating jobs is instead causing cash to be held until morale improves.
Savers are getting ripped off. Interest rates are near zero, yet the inflation rate as of October 2012 was 2.2 percent, which means real interest rates are negative 2 percent, so savings are being diluted by 2 percent a year. It's a stealth, non-voted-on tax, maybe as much as $200-300 billion a year. This is not news. The Roman emperors debased their coins from 4.5 grams of pure silver to less than a tenth of a gram over a few centuries. Hardly anyone noticed until the Visigoths (or was it the Vandals?) showed up to sack Rome. The U.S. dollar has been diluted by 96 percent since the Federal Reserve was created 99 years ago. Modern vandals!
But until ZIRP, no one really noticed. If you got 5.25 percent on your passbook savings account back in the '70s, you thought you were making money, even if the inflation rate was higher. Same for 2.4 percent returns in money market funds in, say, 2007. Two percent inflation and corresponding interest rates are considered stable. It's an old trick. The European Central Bank official edict declares that "in the pursuit of price stability, it aims to maintain inflation rates below, but close to, 2 percent over the medium term."
Think about it. If interest rates are zero, you might as well stuff hundred dollar (or euro) bills in your mattress. Why risk giving it to banks for no return? But at 2 percent inflation, you can't hold onto cash, else you lose 2 percent each year. So you put it in banks, or, if you are a corporation, invest it for a higher return. The spreadsheets are believable. At 5 percent inflation, you might as well spend it now on that Deere Riding Mower or Ducati Monster 796 rather than wait and see prices rise.
So the eggheads at the Fed are conceptually right and real-world wrong. Bernanke's in office for another year, and it's doubtful Obama will reup his membership at the Fed. So why not junk the ZIRP today and let interest rates rise, most likely to 2-2.5 percent, reflecting current inflation expectations? Several things will happen—rising rates would restore a generation of savers, unleash a torrent of corporate spending, which will create jobs, and yes, cause federal interest payments to rise, which may force rationalization of unnecessary government spending. Why is any of this a bad thing?

Sounds pretty good to me.

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