Near-Zero Interest Rates: Good, Bad, and Ugly

Fed plan to keep rates low for two more years saves taxpayers money, but costs investors and consumers

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The Federal Reserve's recent decision to keep interest rates near zero for two more years will have a major impact on seniors and retirement plans. The Fed said it took the action because it felt continued low rates would encourage economic expansion. But the Fed's decision was opposed by three voting governors, an unusual response to what are outwardly collegial and often unanimous votes.

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Keeping credit costs very low is supposed to encourage business borrowing and economic expansion. But there is little recent evidence that this is happening. Big businesses have already built up big cash reserves and are not investing these funds. Part of the reason is that they are more cautious coming out of the recession. But it's also true that they are not investing because they can't find attractive uses for their capital.

Smaller businesses might be more interested in borrowing money to grow. But they continue to have problems qualifying for bank loans. Perhaps banks are being too conservative in their loan standards, but it's also true they have trouble seeing attractive returns on such investments.

The underlying problem with business expansion is not a dearth of capital, but a serious shortage of confidence. And while the Fed's action was supposed to help shore up that confidence, its actions did not prevent the stock market from continuing a volatile slide that has now taken roughly 2,000 points off the Dow Jones Industrial Average.

Like many fiscal and economic issues these days, it's possible to find distinguished experts on both sides of the Fed's interest rate policies. Here are the major impacts of continued low interest rates:

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Federal deficits. The Fed's low-rate policy is great news for the U.S. Treasury. It can continue to finance the nation's growing budget deficits by selling securities with very low interest rates. By keeping borrowing costs very low, the consequences of deficit spending are minimized. Is this good news, or does it merely let leaders "kick the can" down the road?

U.S. exports. Low interest rates in the United States encourage investors in our debt to seek higher returns elsewhere. This reduces demand for the U.S. dollar, and a cheaper dollar translates into lower prices for foreign buyers of American-made goods. Exports have been a relative bright spot during the weak recovery from the recession, although they dipped in July from June's total. The Fed's policy means continued support for exporters.

The dollar, part one. Low interest rates may depress the value of the dollar, but the Fed is well aware that the dollar remains the world's dominant reserve currency. Despite Standard & Poor's recent downgrade of American debt to a rating of AA+ from AAA, demand for U.S. treasuries has soared. Investors concerned about falling stock prices and shaky European economies have flocked to safety, which means buying treasuries. This demand has pushed interest rates on Treasuries even lower, further reducing U.S. borrowing costs. No other nation can increase its deficits while simultaneously lowering its borrowing costs. Again, is this a good thing, or does it just create a false lack of urgency for the U.S. to tackle its budget problems?

The dollar, part two. While a lower dollar makes our exports more competitive, it has the opposite effect on imports. The dollar has fallen by roughly 20 percent over the past year, notes Madeline Schnapp, director of macroeconomic research at Trim Tabs Investment Research. If a foreign product seller had been getting $20 for its products, it would have to raise prices to $25 to receive the same "purchasing power" for its sales dollar as it had last year. While weak economic conditions may prevent import prices from rising by that much, there's no doubt that a falling dollar raises prices that consumers pay for oil and other imported goods.

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"The more the Fed creates money, the more the dollar devalues, and the more the dollar devalues, the more things cost that we have to buy that aren't made or provided here," Schnapp says, "Job number one of our policymakers should be to protect the dollar and protect the value of people's wealth," she adds, calling low interest rate-weak dollar policies "criminal." "It isn't gasoline that's rising at the pump, it's the value of the dollar falling," Schnapp says. Driving down the value of the dollar "is such an insidious way to steal money from people."

Retirement investments and pensions. Not surprisingly, Schnapp is among the rising number of Fed critics who view zero interest rates as reflective of a "Raid and Trade Economy." Yields on CDs and other conservative retirement investments are driven down to near zero (the raid) and these funds are effectively transferred to financial institutions (the trade), who use free money to fund assets on which they make a profit.

"My 85 year-old mother is in bad shape today in terms of her income," Schnapp says. "Unless she risks her assets right now [on stocks and other higher-yielding investments], her income on those assets is zero." In other words, the only way to generate retirement income is to go against the standard advice of retirement experts and invest in higher-risk assets. The recent plunge in market values is painful evidence of the consequences of higher-risk investing. And it's affecting pension plans as well as individuals. They face the same challenges of generating safe returns in a zero-rate environment. Not surprisingly, pension plans generally have been hammered down in value since the market began falling.

Twitter: @PhilMoeller