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  • How Artificial Interest Rates Affect Us Consumers

  • At Robert Floris’ office, we have been concerned with lower, artificial, mortgage interest rates for the past several years. Although the article below, is American, we can easily exchange the same values and financial principles in Canada. This is the reason why we have encouraged our clients to lock in with a long-term mortgage. A lot of our views, regarding mortgage financing can be viewed at www.hamiltonmortgageexperts.ca

    Over the past decade or so the Federal Reserve (the Fed) has used monetary policy to drive down interest rates below market levels. They have done this through keeping the Fed funds rate low and through quantitative easing (QE) – the creation of dollars out of thin air in order to purchase U.S. Treasuries and mortgage backed securities.

    Wall Street and Main Street cheer on lower rates because they make access to dollars cheaper. With cheaper access, people have more money to spend, their debts are easier to pay off and stocks and real estate prices rise.

    It’s all good, right? Maybe not. Here is the dark side of artificially low interest rates.

     

    Artificially low rates:

    Discourage savings and investment by individuals and companies

    Savings and investment provide the capital needed to create productive capacity that is self-sustaining. Low rates discourage savings as the return on savings is de minimis. Therefore, when rates are artificially low, some capital gets diverted from productive investments where there might be a long term return on investment, and flows instead towards either speculative ventures or assets (like real estate) with the potential of large returns, or towards the purchase of consumer goods.

    Things may go well for a while as the artificially low rates spur rising stock and real estate prices. As rates rise, however, gains on unprofitable speculative ventures often evaporate and the bills must be paid on the consumer goods. Share prices of speculative companies with no earnings crash, companies go out of business and workers are laid off. On the consumer side, spending slows, the consumer goods have been used up and there are little or no savings to repay consumer debt.

    Without the lower rates the economy has a weak foundation upon which to support itself as insufficient productive capacity has been built or capital saved during the period of artificially low rates.

    Encourage Excessive Consumption

    People who can borrow to take advantage of low interest rates will often increase their spending on consumption. They will buy cars, boats, automobiles, homes and high priced speculative stocks.

    When money is on sale, we spend more. So when rates are artificially low, people and countries spend instead of saving or paying down debt.

    A good portion of the consumer goods purchased in the United States are produced overseas. In the U.S. this is especially troubling as the consumption of foreign goods doesn’t create high paying jobs in the U.S. and increases the trade deficit.

    Low rates cause people to spend in excess of their incomes as they believe the economy is improving and good times are ahead. When rates rise the debts need to be paid but there is no corresponding increase in wages to pay for them.

    Because the Federal Reserve has engineered artificially low interest rates for more than a decade, a culture of spending has become engrained in the country’s culture. What we spend is more important than what we produce. Indeed, spending money is now considered to be a patriotic duty.

    Encourage Malinvestment by Sending False Signals

    When investments are made during a period of artificially low interest rates they are often malinvestments as the low rates may send false signals to entrepreneurs and home buyers that the economy is good and investments/purchases should be made. The Fed has driven interest rates down precisely because the economy is not doing well and to encourage, rather, trick entrepreneurs and consumers to employ capital in places they otherwise might not spend or invest.

    Austrian economists argue that artificially low interest rates fool entrepreneurs into making investments they otherwise would not make. We think, rather, many entrepreneurs understand the artificial nature of the low interest rates but nonetheless take advantage of them, hoping interest rates stay low long enough for their projects and profits to be realized. Consumers and home buyers, on the other hand we believe are fooled by artificially low interest rates as to the underlying health of the economy.

    Over the past year home builders have been building more spec houses based on the demand they see from the artificially low rates and a temporary inventory shortage. Should this dynamic turn out to be ephemeral they will have miscalculated demand and many of their homes will remain vacant and they will incur losses.

    Lord Maynard Keynes was a proponent of stimulating the economy to bring forward demand when the economy was in recession. In reaction to criticism that stimulus spending would in the end create problems further down the road, Keynes remarked “in the end we are all dead”. The problem with this type of thinking is tomorrow often comes and the bills for yesterdays’ excesses must be paid for.

    Aesop’s The Grasshopper and the Ant fable comes to mind.

    Create Wealth Inequality

    Low interest rates are only a benefit if you can take advantage of them. The main beneficiaries of low interest rates are those who have access to credit, own stocks and real estate (i.e. those in the wealthier income brackets). Those not owing stocks or real estate miss out on the appreciation of stocks and lacking good credit can not participate in the housing market.

    As home prices rise, wealth disparity is created between home owners and non homeowners. Homeowners get richer merely by occupying homes while renters don’t obtain the same passive benefits.

    Homeowners also gain access to cheap credit not available to renters in the form of low interest home equity loans and benefit from the mortgage interest deduction.

    Punish Savers

    Many retired people relied on fixed income to fund their expenses. They saved for years to build their nest eggs for their retirement but are seeing their savings run out because of dramatically reduced fixed income interest payments.

    Are Inflationary

    Inflation is defined as the increase in the supply of unbacked money and credit. Inflation in the price of finished goods comes soon thereafter. The Fed has created inflation through QE. The reason the consumer price index is not registering double digit increases (putting aside the methodology of its calculation) is because the Fed is battling deflation that naturally occurs after a bubble bursts. QE has caused price inflation in stocks and real estate and in the automotive market. Because credit is cheap and readily available the prices of cars have risen to an all time high.

    Cost a Lot to Engineer and to Maintain

    The Fed’s QE program to date has pumped more than $3 trillion of money printed out of thin air into the economy, or rather the banks and the U.S. Treasury. The beneficial results are only evident in higher stock and real estate prices. Job and wage growth is almost non existent with the labor participation rate at a thirty-two year low. The gains in the stock market can be wiped out in a matter of minutes and home prices can also drop quickly. The labor market certainly won’t improve after a stock market crash.

    Earlier this year when Chairman of the Federal Reserve Ben Bernanke first started talking about tapering the $85 billion a month QE program he was thinking that the Fed could keep the Fed funds rate low while tapering the size of the QE purchases and still achieve low interest rates. Mr. Bernanke found out soon that even talking taper would cause rates to rise irrespective of where the Fed funds rate is. Since the Fed knows the economy is weak and can’t withstand higher interest rates it knows that rates must be kept low. Rates won’t stay low just because the Fed keeps the Fed funds rate low – it will require more QE.

    Will Move Higher

    All manipulation schemes eventually become overwhelmed by natural market forces. The Fed’s QE program is entering its sixth year. Eventually the market will demand higher rates for the risk of extending credit to a sovereign that meets its obligations by printing the difference. When that happens the party that was enjoyed be a small segment of the population will be over.

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