Dangers Lurk in Fed's Zero Rate Policy

Former Federal Reserve chairman Ben Bernanke argues in a new blog post that low interest rates are a reflection of the state of the economy and that a zero interest rate policy will somehow improve economic growth and employment. But he forgets the warnings of economists such as Walter Bagehot and John Maynard Keynes about the dangers of keeping interest rates too low for too long.

In fact, both zero rates and quantitative easing, or QE, are actually making deflation worse. (Although the Fed officially ended its bond-purchasing program in October 2014, it continues to reinvest proceeds from the bonds it already owns.) These policies are also causing a precipitous decline in consumer demand, which is visible in lower prices for key commodities such as copper, oil and natural gas. And they come at a long-term cost to individual investors and financial institutions.

In the fourth quarter of 2014, the total cost of funds for all U.S. banks was just $11 billion, versus over $110 billion in 2008. Meanwhile, as Kroll Bond Rating Agency observes in a research note, banks earned $119 billion in gross interest income in the same quarter — illustrating the huge wealth transfer from savers to debtors occurring under the Fed’s policy of financial repression. Savers and investors do not live in the theoretical world of “equilibrium interest rates.”

Net interest income for U.S. banks is higher than ever in dollar terms. But the negative impact of low interest rates is clearly reflected in falling returns on earning assets. U.S. banks earned $108 billion in net interest income in the fourth quarter, just 0.69% of the $15 trillion in total assets, versus 0.80% in 2010, when system assets totaled just $13.3 trillion, according to the Federal Deposit Insurance Corp. In other words, bank assets increased by 12%, but income per dollar of assets fell almost 10%.

Bank earnings and asset returns are likely to continue experiencing pressure through 2015 and beyond as institutions try to offset declining net interest income with efforts to boost fee revenues and reduce operating costs. But more importantly, the steady decline in bank asset returns provides a striking illustration of why the Fed’s policies of zero interest rates and quantitative easing are not working.

The decrease in banks' interest expense comes directly out of the pockets of depositors and investors. John Dizard of the Financial Times wrote recently that it has become mathematically impossible for fiduciaries to meet beneficiaries’ future investment return target needs through the prudent buying of securities.

The stated goal of the Fed's policies is to boost economic growth and employment. But in practice the policies fall short of the mark, because zero interest rates are taking trillions of dollars in income annually out of the global economy.

While the Fed pays banks 25 basis points for bank reserve deposits, the remaining spread earned on the Fed’s massive portfolio of Treasury and agency securities purchased via quantitative easing is still being transferred to the U.S. Treasury. This policy does nothing to support private credit creation or job growth. Indeed, the Fed should increase the rate paid on bank reserves immediately and thereby neutralize transfers to the Treasury.

Moreover, zero rate policy as practiced by the Fed and now by the European Central Bank is actually depressing private-sector economic activity by taking money out of the hands of consumers and businesses.And by using bank reserves to acquire government and agency securities via QE, the Fed has been artificially pushing up the prices of financial assets around the world even as income and GDP stagnates. Public companies are using low interest rates to fund stock buy-backs instead of making new investments.

Higher asset prices due to purchases by the Fed and ECB under QE are clearly a temporary phenomenon. Without a commensurate increase in national income — impossible with zero interest rates — the elevated asset prices resulting from QE cannot be validated and sustained. Thus with the end of QE in the U.S. and the possibility of higher interest rates, global investors face the decline of valuations for both debt and equity securities. This reality is already weighing on global financial markets.

Zero rate policy and QE do not address the core problems of hidden off-balance-sheet debt that caused the 2008 financial crisis. That is, banks and markets globally still face tens of trillions of dollars in on- and off-balance-sheet debt that has not been resolved.

Bad debt is a drag on economic growth, from German banks' loans to Greece to underwater mortgage loans in the U.S. Governments in the U.S. and EU refuse to restructure the bad debt because doing so would force banks to take losses and incur further expenses for already cash-strapped governments. But no matter how low interest rates go and how much debt central banks buy, the fact of financial repression in which savers are penalized to the advantage of debtors has an overall deflationary impact on the global economy.

To be clear, the Fed was right to aggressively lower interest rates after the 2008 crisis. But continuing with zero interest rates and quantitative easing for seven years after the crisis is in conflict with the goal of increased employment and growth. By robbing individual savers and financial institutions of income, and artificially boosting asset prices, the Fed and ECB are unwittingly creating the circumstances for the next financial crisis.

The Fed and ECB should therefore abandon zero rates and quantitative easing and move to gradually increase interest rates to restore cash flow to the financial system. Mr. Bernanke and his former colleagues on the Federal Open Market Committee ought to recall Adam Smith's famous dictum that the “great wheel of circulation" is the means by which the flow of goods and services moves through the economy. If the Fed really wants to fight deflation and eventually hit a 2% inflation target, then we must embrace policies that make the proverbial wheel turn faster, not slower. We can do this by gradually ending financial repression and restoring balance to global monetary policy.

Christopher Whalen is senior managing director and head of research at Kroll Bond Rating Agency, where he is responsible for financial institutions and corporate ratings. He is co-author of the new book Financial Stability: Fraud, Confidence & the Wealth of Nations. Follow him on Twitter at @rcwhalen.