Why the Fed's Zero Interest Rate Policy May Be Dangerous

The Federal Reserve's policy of keeping interest rates super-low has a zippy acronym: ZIRP (Zero Interest Rate Policy). In his recent testimony to the House Financial Services Committee, Fed Chairman Ben Bernanke said that record-low interest rates are necessary until the current economic recovery reaches a solid footing.

Bernanke repeated his pledge that the Fed's primary interest rate will remain at an all-time low near zero for an "extended period." The target range for the federal funds rate has been between zero and 0.25% since December 2008, shortly after the global financial markets suffered a severe meltdown.

The assumption behind ZIRP is that raising rates too soon could sink the recovery and trigger a so-called "double dip" recession. While Chairman Bernanke said he would raise rates once the economy was back on its feet, he did little to calm the growing fear that that Zero Interest Rate Policy is feeding another speculative asset bubble.

Kansas City Federal Reserve Bank President Thomas Hoenig was not so circumspect. In a recent interview on CNBC, Hoenig said that an extended period of ultra-low interest rates invites speculative behavior. "When you have zero rates that go on indefinitely, you are inviting future problems," he said.

ZIRP encourages risky financial speculation in a number of ways, and as a result, many observers believe it is actually a highly dangerous and potentially destructive policy.

Bonds Have "No Value"?

Near-zero interest rates have these pernicious consequences:

1. Savers, investors and money managers are driven into risky assets if they wish to earn any yield on their cash. When savings accounts and certificates of deposit earn essentially zero, then everyone from mutual fund managers to households is forced to look elsewhere for a return on their capital.

This also reduces the cash deposited at banks, sapping their ability to lend. Higher interest rates -- in the Fed's view, a terrible, frightening prospect -- would actually draw cash into banks, which desperately need to bolster their cash reserves in order to lend money to creditworthy businesses and homeowners.

2. ZIRP effectively reduces banks' ability to earn money on their deposits and assets, further weakening their cash flows. The respected Institutional Investor Analyst report went so far as to say: "When the Fed embraces a zero rate policy, what they are telling investors is that bonds and other rate-sensitive financial assets have no value."

In a healthy economy in which capital is rewarded with attractive interest rates, banks earn money on deposits and money-market funds. Under ZIRP, banks cannot earn much on their depositor's cash. As a result, loan portfolios and assets overall are shrinking at an accelerating pace -- exactly the opposite of what the financial sector and economy needs.

3. Zero interest rates on Fed loans to banks encourages financial institutions to speculate in "carry trades" -- borrowing money from the Fed for next to nothing and then sending that money overseas to buy bonds and securities in other countries where the interest rates are higher.

This is a "no lose" trade for the U.S. banks: Borrow from the Fed at 0% and then go abroad to earn higher rates. The problem is that this draws money out of the U.S. economy right when the Fed is supposedly trying to encourage growth in the U.S.

4. This incentive to place cash in risky assets to earn a yield above zero exposes that cash to speculative losses -- just the sort of losses the U.S. households and banks can ill-afford.

The very foundation of capitalism is capital-cash, which earns a return when it is deposited in banks which lend the cash to creditworthy borrowers for a profitable yield. The Fed's zero-interest rate policy effectively destroys the incentive to put money in low-risk investments and pushes "nest eggs," which should be in safe FDIC-guaranteed accounts into inherently risky assets such as stocks, long-term bonds and overseas assets, which are vulnerable to currency fluctuations.

5. ZIRP encourages banks to speculate in high-risk assets and trades. Just as it creates an irresistible incentive to engage in high-yield overseas carry trades, it is also an open invitation to borrow at zero interest and gamble that "free money" in various asset plays, in the hopes that the gambles will enable the banks to pay high dividends to shareholders and hundreds of millions of dollars in bonuses to the traders and management.

Should the bets go bad and the bank lose money, they know the Fed will just lend them more.

When banks are insulated from the risks of their traded by the Federal government or the Federal reserve, this raises the issue of "moral hazard." Since the Fed and Treasury have already made it clear that large banks are "too big to fail," then enabling them to borrow money at zero interest rates and then gamble those funds without having to worry about going broke.

A non-partisan group of respected economics, including Nobel prize-winner Joseph Stiglitz and bailout watchdog Elizabeth Warren, recently issued a 146-page report warning that ZIRP and the other Fed "quantitative easing" policies are setting up another financial crisis which might dwarf the 2008 meltdown.

Is the Fed's zero interest rate policy really good for the nation? Though Fed Chairman Bernanke has made it abundantly clear that he believes it is, the evidence that ZIRP is perniciously undermining the financial sector and the U.S. economy is increasingly persuasive. Perhaps rewarding savers and prudent lending is a better policy than enabling under-capitalized banks to gamble "free" ZIRP money on risky bets that end up being covered by U.S. taxpayers.