5 Reasons Why Low Rates May be Harmful To The Economy

By Rick Rieder | Updated July 30, 2014 AAA

Late last month, the Federal Reserve (Fed) revised its interest rate forecasts due to expectations of faster economic growth, raising its projections for the federal funds rate in 2015 and 2016.

The Fed may be anticipating a need to normalize rates sooner than many market watchers expect is good news. Why? In my opinion, excessively low rates may actually be inhibiting U.S. economic growth and job creation in these five unintended ways.

Older workers are delaying retirement and staying in the workforce. Excessively low rates are making it expensive for individuals to retire, as potential retirees view investment income generation from fixed income products as too meager to support a reasonable standard of living. As older people are staying in the workforce longer, they’re crowding out younger workers and stunting the job prospects of the young.

Companies can’t gauge the true level of U.S. economic growth so they’re holding off on committing capital. Persistently easy policy has masked organic economic conditions, making it difficult for company leaders to gauge the true level of U.S. economic growth, i.e. growth in the absence of extraordinary monetary policy. As a result, corporations are waiting for greater certainty regarding underlying economic conditions before committing capital, and they’re delaying or reducing investment and hiring, and growing their cash balances.

Companies are taking advantage of extremely easy corporate financing conditions at the expense of reinvesting in organic business growth. Given current low-rate conditions and very cheap financing costs, many companies have been using debt issuance to aggressively buy back their stock or pay dividends. But while this debt/equity arbitrage may improve earnings-per-share growth, equity prices, and perhaps even flatter the performance of some corporate management teams, it may well be stunting growth-oriented capital projects.

Inflation emanating from building wage pressure may be more difficult to contain than the Fed anticipates. In recent years, the labor market has split into two segments thanks to a mismatch between the skills required for jobs and the skills that workers have – those with appropriate skills are getting jobs and those without such skills are making up the long-term unemployed. Given this job opening-worker skill mismatch, since the Fed began its monetary easing efforts, job openings have increased, and the cyclical component of U.S. unemployment has improved. As a result, though significant wage gains for workers have been lacking and long-term unemployment remains a problem, wages are trending higher for those workers with the appropriate, desired skills.

This wage inflation could potentially continue for several years and raises the possibility of higher levels of inflation in the medium term. It’s also worth noting that the U.S. capacity utilization rate is currently hovering around a post-recession high of 79%. The last time capacity utilization was at today’s levels the Consumer Price Index (CPI) sat at 3.5%, not today’s near-zero levels, another sign that higher levels of inflation could be on the way:

Capital is being misallocated. Finally, unconventional monetary policy of recent years has encouraged significant bouts of capital misallocation, resulting in crowded trades, correlated risks and the overly stretched valuations seen in markets today. These in turn, are increasing systemic risk, raising the potential for a violent capital unwinding.

To be sure, despite the Fed’s recent rate projection revisions, interest rates are still likely to remain historically low for the foreseeable future. That said, I welcome signs that the Fed may be anticipating a need to raise rates sooner than previously expected, opening the door to merely “easy” monetary policy from “excessively easy” policy.

Given the five unintended consequences I highlight above, I’ve grown skeptical of the usefulness of excessively low policy rate levels, which may now be harmful to the U.S. economy and labor market. The utility of the Fed’s zero interest rate policy is now exceeded by the costs, similar to what happened to quantitative easing before it.

The bottom line: As I’ve mentioned before, select fiscal initiatives (like training to help address the job opening-worker skill mismatch) would be significantly more beneficial to the economy and labor market than continuing overly-easy interest rate policy.

Source: BlackRock Research

 

Investopedia and BlackRock have or may have had an advertising relationship, either directly or indirectly. This post is not paid for or sponsored by BlackRock, and is separate from any advertising partnership that may exist between the companies. The views reflected within are solely those of BlackRock and their Authors.

 

 

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