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The Fed’s Winners and Losers – Ultimately, We’re All Losers

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When the Federal Reserve artificially manipulates interest rates, it’s messing with our minds by distorting important signals that prices provide in a free market. As investment guru Jim Grant put it in a recent article in Barron’s, central bank interest rates are nothing but crude price controls.

Like all price controls, the Fed’s interest rate mechanizations create some winners and some losers. But in the long run, the distortions caused by the central bank’s interventionist monetary policy makes us all losers.

Basic economic theory tells us price controls distort supply and demand curves. We see this in the housing shortages caused by government imposed rent controls. As Grant explains, Fed interest rate policies are nothing more than a mechanism to control the price of credit. And like all price controls, they create distortions.

It’s a spotty form of control, granted—the bond market, where it’s allowed to function, still has a say in determining the price of credit. But central bankers’ thumbs press heavily on the scales.”

“So what?” you might say. Surely the central bankers know what they’re doing. But do they, really?

The biggest problem is that the constant tinkering with interest rates create massive distortions in the economy. And while they may help some people along the way, they hurt others. Grant points to the housing market. You’ll remember that distortions in the real estate market created low interest rates coupled with government policy led to the 2007 crash and the ensuing Great Recession. Did the central bankers learn their lesson? Apparently not. In the wake of the financial crisis, the Federal Reserve pushed interest rates even lower and left them there for nearly a decade.

As Grant points out, this has certainly been a positive development for homeowners – the winners in this scenario. The price of houses has increased by 52% in the last decade. But there are losers as well.

That has been a boon for homeowners, and even for home flippers (they’re back), but no boon at all for the 35% of Americans who rent. Since March 2009, consumer-price-index-calculated rents are up by 32% (as much as the rise in medical costs), against a 26% rise in nominal hourly wages. Then, too, outside New York, the apartment-dwelling portion of the population tends not to be the most affluent one. It’s the same population that derives no immediate benefit from corporate share repurchases conducted with proceeds of borrowed money at near record highs in equity valuations.”

And while creditors have benefited from the central bank’s manipulation, savers have suffered. According to a Wells Fargo analyst, American depositors have forfeited $500 billion to $600 billion in interest income over the past 10 years. That’s just assuming deposit rates would have been at least one percentage point higher in the absence of central bank control.

This is the essence of the business cycle. Artificially low interest rates incentivize speculative borrowing and discourage savings. This is meant to “stimulate” the economy by driving up demand. It works – in the short run. But the lack of savings hinders capital formation and you can’t have a healthy economy over the long-term without capital investment. Eventually, the stimulus wears off and the bubbles burst.

The housing market isn’t the only place we see these economic distortions today. Speculative-grade corporate debt has “shockingly deteriorated.” In January 2007 – on the cusp of the Great Recession – 19.7% of subinvestment-grade borrowers were rated on the bottom rungs of Moody’s scales. Today, 43.6% of these borrowers are within that designation.

As Grant explains, artificially low interest rates are “disinhibitors.”

They stir the blood, liberate the imagination, and quiet the still small voice of reason that can’t seem to get a word in edgewise. That voice would like to remind us that tiny yields forever lead to ‘impulsivity, disregard for financial norms, and faulty risk assessment.’ They cause sober investors to behave as if a jigger of scotch had been poured down their throats and into their empty stomachs.”

The thrust of Grant’s argument is that the Federal Reserve creates winners and losers. But in the long run, we all come out on the losing end of the bargain.

Radical monetary policy, and the interest rates that go with it, advantage some, punish others. Speculators gain, savers lose. The rich do better than the poor. On balance, has the decade-long experiment in interest-rate suppression yielded the expected net benefit? The answer—no’—is best explained by the first economist who uttered the five wise words, ‘There ain’t no free lunch.'”

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