Why the Fed's Making a Big Mistake

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For years, the Federal Reserve has kept interest rates as low as they can go, as well as seeking out novel ways to juice monetary policy even further. In the short run, those moves have typically had their intended effect, boosting financial markets and preventing the wholesale deflation that plagued the economy during the Great Depression in the 1930s.

Few economists, however, would ever have expected that the Fed would keep rates this low as long as it has. Although policymakers obviously want to avoid the apparent folly of tightening monetary policy at a fragile turning point for the economy, there are a number of ways in which the long period of low interest rates has created disturbing trends -- trends that are proving to be more counterproductive than useful in guiding economic behavior going forward.

Time's running out
During ordinary times, lower interest rates drive economic growth by spurring investment. Because savings pay little and borrowing for new business projects is cheaper, companies have greater incentives to invest more. In effect, low rates set the bar lower for new investment opportunities to be successful, allowing companies to do some things that wouldn't have been profitable at higher interest rates.


But earlier this year, St. Louis Fed CEO James Bullard argued that although keeping rates low for short periods of time makes perfect sense, keeping them low over the long haul can have detrimental effects. Bullard gave examples of how savers got punished under such a policy. Yet even more important, he noted how the current economic environment, in which unemployment is high and lending standards are tougher to meet, has actually held people back from taking advantage of lower rates.

Lacking a sense of urgency
Other observations point to how the long period of low rates has arguably had a counterproductive impact on the economy. In housing, a number of factors have kept demand weak in recent years, including difficulty in getting mortgage loans and uncertainty about how long price declines may continue.

But one thing that is clearly holding potential buyers back is a lack of overall urgency. If you believe that mortgage rates will continue to fall, then it's silly to buy a home now when you'll be able to get it at an even lower overall cost by waiting.

By contrast, though, if the Fed threatened to raise rates, it would drive homebuyers to believe that they wouldn't get better conditions by waiting. Higher rates would make monthly mortgage payments more expensive even if prices stayed stable, and so those who have simply been waiting to try to get the best bargain possible would get driven off the sidelines in a buying spree. That in turn would help a host of companies, from Standard Pacific (NYS: SPF) and its fellow homebuilders to home-improvement retailers and many affiliated businesses with ties to home construction.

Buying the wrong investments
Another way the Fed's low-rate policies are changing the economy is by influencing corporate policy on capital management. In particular, because traditional fixed-income investments haven't really produced much income lately, companies are under pressure to increase dividends even at the expense of giving up on potentially more profitable strategic moves.

Admittedly, companies have a mixed track record at best on squandering capital through takeover bids and share buybacks. But low rates have increasingly encouraged high-risk, cash-flow-producing investments like the leveraged mortgage bets that Annaly Capital (NYS: NLY) and American Capital Agency (NAS: AGNC) use. At the same time, as Apple (NAS: AAPL) and Dell (NAS: DELL) join the many companies that have recently initiated dividends, they represent the latest examples of businesses that can't find any more lucrative prospects for spending their cash other than returning it to shareholders.

Setting a finish line
At this point, just the idea of a possible end date to low rates might be enough to spur companies and individuals to get more active in taking economic risk. As long as decision-makers expect the Fed to give them all the time in the world before forcing their hands, the impetus toward greater economic activity from lower rates won't work nearly as well as policymakers would hope.

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At the time this article was published Fool contributor Dan Caplinger has wrestled with falling rates for years. He doesn't own shares of the companies mentioned. You can follow him on Twitter @DanCaplinger. The Motley Fool owns shares of Annaly Capital and Apple. Motley Fool newsletter services have recommended buying shares of Apple and Annaly Capital, as well as creating a bull call spread position in Apple and writing naked calls on Standard Pacific. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Fool's disclosure policy never falls down on the job.

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