Fed's zero rate policy sparking growing complaints
Posted: 26 November 2009 1003 hrs

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WASHINGTON: The Federal Reserve's zero interest rate policy is provoking growing complaints from some economists who argue it is doing little to spark lending activity and may be fuelling new asset bubbles.

Few expect any immediate hike in the federal funds rate, which has been in a range of zero to 0.25 per cent since last December in an effort to jolt the economy from recession.

But some economists said the Fed is running the risk of falling into a "liquidity trap" in which monetary policy, no matter how stimulative, fails to spark new lending or growth.

Joel Naroff at Naroff Economic Advisors said holding rates at zero has a psychological impact but probably offers little more for the economy than a rate of one per cent, which would under most circumstances be considered exceptionally low.

"This idea in the minds of so many people that the Fed needs to keep rates at zero through 2010 is very dangerous," said Naroff.

"I would be concerned if we are still at zero per cent next November. It would mean the economy is in trouble, and the potential for bubbles is greater."

Analysts said most banks are content to borrow "free money" from the Fed and invest in US Treasury bonds for a modest yield, as part of the effort to repair their finances, rather than take the risk of loans to consumers or businesses.

Other banks and funds are able to borrow at ultra-low rates to invest in higher-yielding assets such as commodities, or Asian government bonds or real estate. This so-called "carry trade" has pushed the dollar down to historic lows and drawn complaints from many governments, notably in Asia.

The Fed on Tuesday acknowledged "that some negative side effects might result from the maintenance of very low short-term interest rates for an extended period."

Ed Yardeni at Yardeni Research said the zero-rate policy is no longer working.

"I don't want to sound ungrateful, but I would like to send another message to the Fed about its current policy: 'Thanks for nothing,'" Yardeni said in a note to clients.

"The Fed's zero interest-rate policy may be inadvertently depressing rather than stimulating the economy," he added.

Yardeni said banks are pulling back on lending "because it makes more sense for them to buy Treasury and agency securities so long as they are certain that the Fed won't raise interest rates."

The low rates enable the US government to issue more debt at a relatively low cost, but Yardeni said this may be crowding out private borrowing.

He said that in Japan, the near-zero rate between 1999 and 2006 "enabled the government to issue lots of bonds at extremely low yields. However, this didn't do much to revive self-sustaining economic growth in Japan. The United States seems to be heading down the same path."

Because of the low rates and weak dollar, Yardeni said that "asset bubbles are already making a comeback in stocks and commodities around the world. The biggest bubble may be in government securities."

He said the central bank "should start raising rates and resist providing any guidance on the likely pace of tightening. Providing strong guidance as to the likely direction of monetary policy simply encourages speculators to take more risk."

Naroff said the economy could withstand a modest hike in rates as long as banks and borrowers have enough confidence to expand credit.

But he said the Fed needs to prepare the public and financial markets with more confident statements about the economy.

- AFP/sc