Sunday, April 11, 2010

The Fed will find itself in a lose-lose situation

Published in The Tennessean, April 11, 2010

The Fed will find itself in a lose-lose situation

by Richard J. Grant

The Federal Reserve Board has a tiger by the tail. It knows it cannot hold on indefinitely; but it fears what will happen when it lets go.

They know that sometime this year they will have to allow interest rates to rise. If they don't, the result will almost certainly be an upsurge in price inflation. But members of the Federal Open Market Committee also fear that if they allow rates to rise "too soon," they risk precipitating more symptoms of recession and prolonged high unemployment rates.

Since late 2008, the Fed has been holding interest rates at artificially low levels to encourage borrowing and to prop up asset prices. But in order to do this the Fed has had to create a lot of new money. During that time, the monetary base, which is the most basic quantity of money, has increased by about 140 percent.

Under normal circumstances the Fed would never have dared to do this. The result would almost certainly have been double-digit, possibly triple digit, price inflation. But the circumstances were not normal: The Fed had already just taken us through a cycle of low interest rates to stimulate artificially a recovery from the collapse of the tech bubble. This was followed by a steady increase in interest rates from 2004 through 2006. The Fed's target, the Fed funds rate, increased from 1 percent to 5 percent. It is now close to zero.

Periods of artificially low interest rates subsidize borrowers at the expense of lenders. Credit is now cheap, if you can get it. Homeowners have been scrambling to refinance their mortgages, while those who depend on interest income, such as retirees, are suffering unexpectedly low incomes. This encourages would-be lenders to shift their funds into riskier investments that offer hope of higher returns.

The important point is that when the Fed interferes with interest rates, people react by taking actions that they would not normally take. Artificially low interest rates bias investors toward overestimating the profitability of their planned projects. That means that more projects than usual will turn out to be unsustainable.

During 2007 and 2008, as information emerged about the true extent of malinvestment in the real estate finance markets, related assets held by most financial institutions had to be marked down in value. Suddenly, many financial institutions found themselves to be undercapitalized and vulnerable to failure. They needed reserves.

The huge amounts of money created by the Fed were almost entirely taken up as reserves by the financial institutions. Although we hear much politically driven talk about the need for more lending, the Fed has been paying banks interest to encourage them to hold more reserves rather than to lend. This also explains why the Consumer Price Index has increased by little more than two percent, rather than rising at double-digit rates.

But prices are higher than they would have been. Had the Fed not injected huge amounts of cash, the financial institutions would have had to liquidate and write down larger portions of their assets. These liquidations, and the resulting credit contraction, would have precipitated more widespread price reductions than those that we actually witnessed.

Given that some prices are fixed by contracts while others would be free to fall, large unexpected changes in relative prices could have caused even greater disruption than what we experienced. But we haven't escaped; we have merely slowed down the adjustment.

As businesses reorganize and gain confidence, banks will have increasing incentive to lend again. To the extent that they shift reserves into loans, the broader money supply will increase. As this occurs the prices of more assets, particularly consumer goods, will be bid up. That is when we will begin to see increased price inflation.

The Fed will react by either withdrawing reserves from the banking system or by slowing down the increase. Either way, we will soon see rising interest rates.

Richard J. Grant is a professor of finance and economics at Lipscomb University and a scholar at the Tennessee Center for Policy Research. His column appears on Sundays. E-mail:

Copyright © Richard J Grant 2010