The Law of Unintended Consequences (Part 2)

Are there limits to the Fed’s effectiveness?

As the Fed continues to provide monetary accommodation, it’s reasonable to inquire whether it will work. After all, low interest rates aren’t a boon for everyone. When short-term rates are below the inflation rate, savers lose purchasing power as prices rise. In effect, savers are subsidizing borrowers. So how do low rates help?

In the short run, low interest rates help the housing sector as they make periodic mortgage payments cheaper. They also make it easier for governments to finance deficit spending, and they reduce the cost of capital for large corporations. These short-run effects can encourage economic growth. But over time, as people come to expect ultra-low rates to last forever, they start to make decisions based on these rates that become distorted.

One clear effect is with government spending. Since the marginal cost of additional spending is minimal, there is an increasing demand for government services. As a result, the size of government relative to the economy increases. At the same time, there is no incentive to increase taxes in order to reduce the deficit, as taxes will have a dampening effect on the economy. The result is an explosion in the deficit and a deterioration in our country’s long-run fiscal stability—our credit rating.

Free money isn’t free. It’s partly why S&P and Egan-Jones downgraded US Government debt. So it’s important for investors to ask, “What comes next?”

Douglas R. Tengdin, CFA
Chief Investment Officer
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