Why the Fed is wrong to pin hopes on low rates

Federal Reserve Chairman Ben Bernanke
Karen Bleier/AFP/GettyImages

(MoneyWatch) COMMENTARY The Federal Reserve said today it would hold off on taking any steps to lift the U.S. economy. The central bank will maintain its federal funds rate -- the rate lenders charge each other for overnight loans -- at zero to 0.25 percent.

In other words, rates will remain where they've been since December 2008 -- and, as the recovery sucks wind, will likely produce the same anemic results. It's not like the central bank doesn't realize there's a problem. Here's how it described current economic conditions:

Growth in employment has been slow in recent months, and the unemployment rate remains elevated. Business fixed investment has continued to advance. Household spending has been rising at a somewhat slower pace than earlier in the year. Despite some further signs of improvement, the housing sector remains depressed.

To be fair, Fed officials aren't saying they intend to sit on their hands as the economy caves. Rather, the Federal Open Market Committee, or policy-setting panel at the bank, "expects to maintain a highly accommodative stance for monetary policy."

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For the last three-and-a-half years, Fed chief Ben Bernanke has tried to get banks to issue more loans to consumers and businesses by keeping interest rates low enough so it is not profitable for lenders simply to keep money stashed away in the safe. With inflation running at between 1.66 percent and 2 percent, the nominal rate is effectively negative. Yet bank lending still remains depressed.

Why? A couple possible explanations:

1) The banks think they risk losing more money via loans than they will sitting on their cash earning interest at the current Fed rate. This suggests the banks think the economy will continue to contract, which would discourage them from boosting lending.

2) The banks are concerned about the amount of bad debt on their books and are nursing their reserves. Even if the housing sector is rebounding, that turnaround is proceeding slowly, which means lenders will continue to carry a lot bad debt on their books for quite some time. A more skeptical view would be that some banks still have debts in excess of their assets.

In the first case, Bernanke may believe that loaning money out will help the economy, therefore removing the reason for not making loans. For that to be true, then the U.S. economy must be at very low risk of collateral damage from the fragile European and Asian economies. Making loans in the U.S. will have, at best, a tangential positive effect on those economies, while an improvement in the U.S. economy would seem to depend more on the level of overseas demand for goods and services.

That argument focuses mostly on the Fed trying to stimulate spending by businesses via loans. If it is also trying to stimulate consumer spending by making banks more willing to boost lending, then it has other problems to address. For consumer spending to improve, people have to believe that their future income is secure enough to justify borrowing against it.

At first glance, the economy does show some signs of improvement. The Conference Board's consumer confidence index was up unexpectedly in July, rising from 62.7 to 65.9. Personal income also managed a solid 0.5 percent gain in June from the previous month, according to the Commerce Department.

However, annual growth in personal income has slowed to just 3.5 percent in June, from 5.1 percent a year earlier. Revisions also lowered the level of income in the 2009-2011 period. Meanwhile, the increase in consumer confidence was the first improvement in four months, and the number remains at historically low levels. 

It would also be wise to consider these other July numbers from the Conference Board: "The Expectations Index improved to 79.1 from 73.4. The Present Situation Index, however, decreased slightly to 46.2 from 46.6 a month ago."

This is not indicative of an economy where demand is only being stymied by lack of access to capital. It seems more likely that as consumers continue to pay down their debts, they feel better about the future, even as they remain doubtful about the present. (Also consider this AP article: U.S. poverty on track to rise to highest since 1960s.)

If the second case above is true, by contrast, then it is difficult to imagine anything short of relaxing capital reserve requirements that will get the banks to lend, and even that might not do the trick.

Having tried and failed for several years to bludgeon the banks into making more loans, Bernanke believes that this time it will be different. Let's hope he's right.

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    Constantine von Hoffman is a freelance writer and writing coach. His work has appeared in outlets such as Harvard Business Review, NPR, Sierra magazine, Brandweek, CIO, The Boston Herald, TheStreet.com, CSO, and Boston Magazine.