President Trump: the Fed's Biggest Moral Hazard

Perhaps the Federal Reserve's biggest problem today is that it has a moral hazard problem with President Trump.  A moral hazard is a situation in which a person can take risks without having to bear the full consequences of those risks.  For example, when stock market investors think the Federal Reserve will cut interest rates to prop up the economy and the stock market should things go downward, they are more willing to buy stocks because they expect a bailout from the Fed.  This can lead to over-investment in stocks and greater potential for an asset bubble that can later burst painfully.

President Trump's trade war with China has created uncertainty.  The economy is slowing and the stock market has been trending downward for several weeks.  Trump has been haranguing the Fed to cut interest rates, evidently in the belief that such cuts can offset the negative impact of his trade war.  There is considerable debate among economists and others whether the Fed can actually prop up the economy and stocks while the President exchanges volleys of tariffs and other trade restrictions with China.  Perhaps the Fed can soften the impact, but it seems doubtful the Fed can do more than slow down the negative impacts of the trade war.  When the Fed lowers rates in what is already a low-rate environment, that signals things are going to be bad.  Businesses pull back, slowing hiring and investment.  Consumers spend less..  The rate cuts could produce a self-fulfilling prophecy.

However, as long as President Trump believes the Fed can offset the damage his trade war does, he has no incentive to act prudently.  He may instead proceed recklessly and then turn to the Fed to put out the fires he starts.  This is an extremely concerning instance of moral hazard, and one for which there is no easy solution (because the President doesn't seem to understand economic reality).  The President could trigger an economic downturn and a bear market with no certainty that he could secure a good trade deal.  And we'd all pay the price.

A Generation of Stagnation; Retirement Walks the Plank

We are now looking at a generation of stagnation.  The recovery from the 2008 financial crisis still wobbles like a drunk.  Even though we now have full employment, wages barely keep up with inflation (if at all).  And recent statistics indicate that inflation is growing as fast as a parched lawn.

Regardless of what this Federal Reserve official or that says, the central bank will raise rates as often as humans walk on Mars.  If you're wondering when rates will return to historical norms, the answer is never.  At least, this is the only rational assumption you can make.  With Asia's growth slowing, Europe's growth nonexistent, South America in free fall, Russia going negative in numerous ways, and the Middle East becoming more unstable with each passing day, and no drivers of growth in America except the Fed money printing presses running 24/7, the only future forecast that seems sensible is to expect stagnation for--well, the rest of your life.

With stagnation instead of brisk economic growth, the government's ability to support retirees will be limited.  While Social Security and Medicare won't disappear, they will likely be parsimonious.  If you drop your porridge bowl, they won't refill it.  And pension fund and personal investment returns are being decimated by low interest rates on bonds and bank accounts.  Your retirement is starting to walk the plank.  What to do, then, about your future?

Spend less, save more.  This is a no brainer.  It's not what the Fed wants, because hesitant consumer demand constrains economic growth.  But the Fed be damned.  Your long term well-being requires the thriftiness of Ben Franklin, and if that results in lower economic growth that makes the Fed look bad, well who cares?  (Or, you can substitute more lively terminology if you wish).  With interest rates so low, you can't use the financial magic of compounding to build much of a retirement (see http://blogger.uncleleosden.com/2009/09/if-you-love-compounding-compounding.html). You have to set aside more principal, and hope that the few crumbs of interest income you get will elevate your retirement diet above dog food.

Put some money in stocks.  The inequality of wealth in America has increased because the Fed's easy money policies tend to inflate asset values.  Since the rich own most assets, their wealth  has increased disproportionately from central bank policies.  Realistically, with stagnant wages and a Republican controlled Congress, you can't expect the inequality of wealth to diminish.  (Maybe things would be different if Bernie Sanders is elected President, but both the Democratic and Republican establishments are using all their smoke-filled back room influence and power to prevent that.)  So you might as well join 'em if you can't beat 'em.  Owning stocks can be gut wrenching in times of market turmoil.  But so is a retirement spent eating dog food.  Learn to live with the market's turbulence, and collect the rates of return that the 1% are getting from equities.

Work longer.  This increases your lifetime earnings, which allows you to save more and build up your Social Security benefits.  If you're lucky enough to have a pension, it will likely increase your pension benefits.  Okay, so working longer means a shorter retirement.  But, like we said, retirement is walking the plank.  Just try to avoid having to live in a cardboard box on the sidewalk with a couple of cans of cat food in your raggedy backpack.

Avoid debt.  You can't go bankrupt if you don't borrow.  If you do borrow, some of your future income will go to banks and other lenders in the form of interest payments, instead of enhancing your future lifestyle.  Granted, you may need to borrow for big ticket items like college, cars and a house.  But otherwise, avoid debt.  And pay down the debt you have as you approach retirement.  Especially, lose the mortgage.  Financial advisers may tell you it's okay to have a mortgage in retirement.  But guess what?  If you have a mortgage, that means you may have more financial assets to invest in ways that pay fees and commissions to the financial advisers.  Meanwhile, you have to pay interest on the mortgage debt.  Who's better off?

For more on ways to yank your retirement back off the plank, read http://blogger.uncleleosden.com/2009/11/techniques-for-retirement-saving.html, http://blogger.uncleleosden.com/2009/07/simplest-financial-plan-of-all.html, and http://blogger.uncleleosden.com/2011/01/hope-for-financially-lost.html.  Good luck.

How the Federal Reserve Destabilizes the Markets and Influences Politics

The Fed is being hoisted on its own petard.  Since 2008, it has suppressed interest rates, keeping them exceptionally low and forcing investors to put savings into risk assets such as stocks and high-yield bonds.  While there were good reasons for taking extraordinary action in 2008 and 2009, the Fed left rates so low for so long that investors, corporate America and borrowers have come to expect that really easy money is the norm, the default.  This dependency has made it virtually impossible for the Fed to normalize interest rates.  If the Fed raises rates, risk assets fall in value (as they did in recent months when faced with the specter of short term rates reaching a ghastly 1% to 1.25% by the end of this year).  The markets simply won't stand for interest rate increases, and the Fed sees itself as having no choice but to do the markets' bidding.  However, as the Fed continues to suppress interest rates, it only increases the markets' dependency, making future rate increases even more difficult. 

The Fed claims its interest rate policy is data dependent, and that it will raise rates as warranted by the data.  The U.S. economy is now at full employment and growing moderately.  Although last month's inflation data show stable prices, the recent rise in oil and gasoline prices will push up inflation numbers for March.  Yet, when it comes to the decision whether or not to increase rates, there is only one data point that matters.  That is the willingness of the financial markets to accept an increase.  With the markets' long term addiction to low rates deeply embedded, and their turbulent hissy fits every time the Fed hints at rate normalization, there is no foreseeable time when interest rates will return to historical norms. 

The Fed is undermining deeply rooted foundations of our society.  Highly rated long term bonds are essential to the stable retirements for which Americans and many other peoples hope.  Shorter term interest rates provide important supplemental income to savers, and promote financial stability and responsibility that mitigate the impact of economic cycles.  When people face lousy retirements (see http://blogger.uncleleosden.com/2015/04/is-federal-reserve-wrecking-retirement.html), and can't count on much of any return on savings (especially after netting out inflation), you can get the political unrest that we see today. 

The Fed is missing an important part of the picture.  People don't just want cheap credit.  They want stable long term prospects.  During the 1950's, 60's and 70's, the World War II generation endured many layoffs and cutbacks, due to recessions, factory retoolings, labor strikes and so on.  But their fundamental faith in the future was unshaken, because they knew they had pensions and Social Security to take care of them in their golden years (which in fact were golden for many of them).  This kind of long term stability isn't evident today.  Instead, havoc permeates today's politics.  Angry voters in America and Europe are upending established political orders because they fear the future.

Personal consumption and wealth have suffered greatly from low interest rates.  From 2008 to 2013, savers lost about $750 billion due to low interest rates (see http://www.cbsnews.com/news/report-low-interest-rates-have-cost-consumers-750-billion/).  Adding in likely losses for 2014 through today, the amount now is probably around $1 trillion.  That's real money.  Take that much out of people's hands, and they feel less secure, less inclined to spend, less inclined to borrow (you borrow less if you have less income), and more angry about the status quo.

What's more, the Fed's insistence on favoring risk assets has exacerbated the increasing inequality of income and wealth.  Rich people have the capital to invest in risk assets, and they become increasingly wealthy when cheap money pumps up the value of those assets.  Those getting the short end of the stick are now turning toward political extremism, because they feel they have no other choice.

The last thing the Fed wants to do is get entangled in politics.  It is supposed to be an independent agency that dispassionately dispenses policy in the public interest.  But the Fed's inability to act independently of the financial markets' short term tantrums is having significant impact on social stability and political trends.  Things will only get worse.  As the fall election approaches, the Fed will find itself in the horns of a dilemma largely of its own making.  If it raises rates because inflation is flaring (which is possible given the recent sharp increases in oil and gasoline prices), it will be accused of tilting the political picture one way.  If it does not raise rates despite an upswing in inflation, the markets will hum along on their cheap credit high, and the Fed will be accused of tilting the political landscape another way. 

The Fed is largely staffed and run by economists.  The economists there have failed to appreciate the diminishing returns of continuing the cheap money IV for the markets.  They have also failed to appreciate the costs of their cheap money policy.  If all they acknowledge is the upside (the return to full employment and moderate growth), and fail to acknowledge the pain they inflict on savers and workers who want to retire, then of course they will continue to inject cheap credit into the markets because they only see the benefits and not the costs.  Economists who don't acknowledge diminishing returns and see only benefits but not costs are bound to get policy wrong. 

The Fed measures its performance by short term metrics--current GDP growth, current unemployment, current inflation.  It doesn't appear to pay much attention, if any, to long term factors.  Long term factors are harder to measure.  But that doesn't mean they aren't important.  By focusing on the short term, and ignoring the long term, the Fed inevitably creates problems.  And we all have to live with the consequences of those problems.

Fed Raises Rates, Civilization Ends

Today, the Federal Reserve raised short term interest rates a quarter point.  Stock up on food, water, blankets, toilet paper and ammo.  Barricade your doors and windows.  Civilization is ending.  Massive hordes wielding pitchforks will rage through the streets.  Entropy will increase.  Chaos will reign.

Okay.

Actually,

in all likelihood, not much will happen in the near future.  A quarter point really isn't a lot.  If the typically usurious credit card interest rate were increased a quarter point, you'd barely notice it, unless you're so deep in debt that bankruptcy is a more realistic option than minimum monthly payments.  If a quarter point increase on your mortgage rate knocks you out as a buyer of your dream home, you were probably about to pay too much for that house.  Money market funds and bank money market accounts have been paying almost nothing in interest.  If they now start paying a quarter point, you won't see a stampede from stocks to money markets.  The only thing that will happen is that savers will start thinking they can add one four-dollar cup of coffee per year to their budgets.

Will the rate increase exacerbate the fallout in the junk bond market?  Maybe by a bit.  Mathematically speaking, higher interest rates imply lower bond prices.  But, again, a quarter point won't greatly change bond prices.  The junk bond losses are, to a large degree, a result of the oversupply in the energy markets (oil and natural gas).  That's not the result of Fed policy.  It's because the energy markets were overstimulated by rapid growth in some parts of the world (especially China) which has now abated. 

The key question is how fast the Fed will raise rates over the one, two and three years.  Rapid increases will, indeed, significantly change the relative values of assets.  But Fed Chair Janet Yellen is signaling that the Fed will be kinder and gentler with rate increases than it has been in the past. 

Could the Fed be making a mistake?  As one former vice presidential candidate would have put it, you betcha.  The Fed has made many mistakes in the past and some of them were egregious.  Stay alert for trouble--the junk bond market, the manufacturing slowdown, China's slowdown, falling commodities prices and who knows what else could signal the next economic dislocation.  But the market was expecting a quarter point increase today, and if the Fed hadn't raised rates, it would have probably created more market turmoil than raising rates causes. 

The Fed's International Data Dichotomy

The Federal Reserve Board is meeting to decide whether or not to raise interest rates.  The costs and benefits of its decision, whichever way it goes, will fall to a large degree along international borders.

Most of the data favoring a rate hike are domestic.  The U.S. economy is growing, moderately but steadily (especially after data revisions).  Unemployment has fallen to the level generally regarded as full employment.  Jobs growth continues, not at a blistering pace but indicative of continued expansion.  Inflation is very low, but if you strip out energy and food prices (which are volatile), the rest of the price structure is pretty close to the Fed's 2% target.

Most of the data arguing against a rate hike is from overseas.  Chinese stocks have been volatile and China's growth is slowing.  Europe's and Japan's economies are  barely growing.  Emerging nations and commodities producing nations are on the ropes, with many facing shrinking economies.  The Greek debt crisis has temporarily simmered down, but the most recent "resolution" was just another kick of the can down the road.  So we can be confident that a Greek default will loom anon, and we'll have to revisit familiar angst.  A rate increase will strengthen the dollar, which will possibly exacerbate these international problems.

Much of foreign anxiety stems from the fact that the dollar is the international medium of exchange.  The entire world uses the dollar in numerous trade and cross-border transactions.  The Fed's monetary policy unavoidably affects people in distant lands.  A rate hike may help the domestic economy by easing asset distortions and increasing certainty (and desperately desired income for savers).  It is likely to have a negative impact overseas.  No wonder the IMF and other voices reflecting foreign perspectives argue against a rate hike.

What will the Fed do?  Most likely, not even the Fed knows before its meeting.  We've been told that its decision is data dependent.  What we don't know is how it weighs and balances the data.  What data receive greater consideration?  What data are downplayed?  What thought is given to the effect of the Fed's decision on foreign relations? Central banking is distinct from diplomacy, but the Fed can't ignore foreign concerns.  A rate hike will produce smiles and frowns, mostly on different sides of the border.  After World War II, America became the pre-eminent economic power in the world, and it cannot now avoid the consequences of its dominance.

An Epidemic of Price Fixing in the Financial Markets

Nothing is more antithetical to the principles of free enterprise than price fixing.  Rigged prices undermine the efficient functioning of markets and defeat their ability to maximize economic welfare.  Sadly, we've had an epidemic of price fixing in the financial markets, frequently involving the largest and most important banks.

The London Interbank Offered Rate has been the subject of governmental investigations in Europe and the U.S. for alleged years-long collusion. Billions of dollars of fines, penalties and other payments have been assessed on various big banks, and the investigation of other major banks continues.  Trillions of dollars of loans and contracts were priced based on Libor, and the potential impact of this price fixing is massive.

Foreign exchange rates have been investigated for rigged prices, and billions of dollars of fines, penalties, etc. have been paid in government and private civil lawsuits.  Again, some of the largest banks are implicated.

Now, word comes that the market for interest rate swaps has been under investigation for price fixing via the alleged collusive manipulation of the ISDAfix, a benchmark swap rate that is used in the pricing of a variety of financial products.  The interest rate swaps market, although obscure to the general public, involves hundreds of trillions of dollars of financial products (in notional value) sold to corporations and other commercial customers to offset interest rate risk.  Big banks are reportedly involved this collusion and the fines, penalties, etc. could total perhaps billions.

There are also reports of investigations of price manipulation by big banks in the metals markets.  These might involve restricting supply and other maneuvers to rig prices.  If wrongdoing is uncovered, more large fines, penalties, etc, can be expected.

Many of the banks involved in these matters are likely to be too big to fail.  In other words, while conspiring against the public in very large and important markets, these banks enjoyed the explicit and/or implicit backing of the taxpayers.  This backing helped them attain Brobdingnagian size, which in turn probably facilitated their ability to rig markets. 

The financial markets are the central venue of the capitalist system, being the place where holders of capital and borrowers of capital meet to determine the allocation of society's financial resources.  The largest banks are at the center of the financial markets, and their conduct ripples through the financial markets and the entire free enterprise system.  That such crucially important players are so regularly conspiring against the public and the public interest presents a galling spectacle that damages the credibility of the capitalist system.  Are markets truly socially beneficial or are they simply a means by which the rich and powerful fleece others? 

The world's largest banks have the legal and social responsibility to refrain from such reprehensible conduct.  However, their sad record of massive, multi-market price fixing seems to tell us that their chances of upholding these responsibilities aren't very high.  Their collusive activities often arise in markets that have a bi-level structure:  an inner inter-dealer market where the big banks and other financial firms trade among themselves, and an outer market where the dealers trade with the public at usually marked up prices.  The inside inter-dealer market is a perfect venue for price-fixing, as the dealers have to talk and trade with each other every business day.  As Adam Smith put it in The Wealth of Nations, "People of the same trade seldom meet together, even for merriment and diversion, but the conversation ends in a conspiracy against the public, or some contrivance to raise prices."

Thus, the challenge falls on regulators and law enforcement authorities to be vigilant and firm.  The sheer magnitude of the wrongdoing, as demonstrated by the billions that have been paid out to date, is astonishing.  Those who may seem paranoid about the financial markets have it right--way too often, the markets are rigged.

How the Fed Told the Market What It Wanted to Hear

One of the most human things about humans is that they tend to hear what they want.  It's easy to take advantage of this trait. Politicians do it as a matter of course.  Many, and perhaps most, Congressional districts are gerrymandered to favor one party or the other, so that members of Congress can be elected, and then endlessly re-elected, simply for saying what their constituents want to hear.  Our gridlocked government doesn't actually do anything.  We pay members of Congress nice salaries simply to say what we want to hear--and in the final analysis the shame is on us.

Government officials aren't above telling us what we want to hear, either.  The Fed's latest policy statement is a good example.  The word "patient" was removed, indicating that there wouldn't necessarily be much warning of an interest rate hike.  This is hawkish. 

But the statement also tried to make nice-nice with all the skittish investors out there who bet on continued money printing by saying that a rate increase in April is unlikely, and that the timing of future rate increases would be dependent on economic data.  The Fed also continued from the previous statement to say that it anticipated moderate economic growth, lower than average inflation in the near term and a continuation of its practice of re-investing principal payments from its holdings of federal agency and Treasury securities into other agency and Treasury securities (thereby maintaining the size of its balance sheet).  These dovish statements softened expectations for rate hikes in the near future.

The market rallied yesterday (Wednesday, March 18, 2015), with the Dow Jones Industrial Average rising almost 230 points (more than 1%).  Today, the Dow dropped 117 points, or 0.65% (although the Nasdaq rose 0.2%).  What gives?  The market initially read the Fed statement to be dovish and drank deeply of the punch bowl.  But Fed Chair Janet Yellen also has made clear that there are no assurances as to June and a rate increase in June is possible.  The market evident sobered up today and took some money off the table.  The Fed statement didn't change from yesterday to today.  What changed was how the market read the statement.

The Fed is now in the position it wants to be in--it can move rates without giving a lot of notice.  It has much more flexibility to react to changes in economic data.  Investors who are caught leaning the wrong way can't expect a bailout.  We're back to the past, to the Fed of the 1970s, 80s and 90s, which tended to be opaque and liked it that way.  It had room to move.  For example, in 1994, the Fed decided to raise rates, when large swaths of the market didn't expect a rate increase.  Many hedge funds and other investors were seriously discombobulated, but there was no money printing done to make the boo boo go away.  All the losers could do was to reflect on how there's a certain amount of rancid cheese in life and you just have to deal with it.

Now, let the investor beware. 

Dreaming of Higher Interest Rates

Today's employment report, which shows a gain of 295,000 jobs and a lower unemployment level of 5.5%, knocked the wind out of the stock market's sails.  The Dow Jones Industrial Average fell almost 279 points or about 1.5%.  Bonds retreated as well, while the dollar rose.  The new employment data heightens the chances of the Federal Reserve Board raising interest rates as early as June, something that's detrimental to today's rosy asset valuations. 

In the past year, there have been innumerable rumblings from hawks and doves on the Fed about when to raise interest rates and how quickly.  As the economy has improved, the Fed's public signals have morphed from waiting a significant time and being patient, toward saying that their decision on rate increases will be data dependent.  That means rates could increase any time, if the Fed decides that the data warrants an increase.  Fed Chair Janet Yellen is a dove on rate increases, but she also wants to have a free hand without necessarily having to be patient.

There's so much debate and angst over rate increases that the sensible thing for the Fed would be to raise rates a quarter point this summer or fall.  That would give the markets a chance to adjust to a world without zero interest rates, something they haven't experienced in seven years.  After an initial tantrum, the market would probably figure out that 25 basis points is just 25 basis points, not the beginning of a massive depression and the end of civilization as we know it.  Some of the heat in the debate over rate increases would dissipate, and the dialogue could become calmer.  The hawks would have had their way, at least for a first step.  And the doves would realize they don't have much to worry about.

That's because economics would dictate that rates should remain low as long as inflation remains low.  Inflation, even without considering the falling price of petroleum, remains below 2%.  There is no economic justification for rates to rise much.  On or two quarter point rate increases would establish that the Fed is not locked into perpetual pedal-to-the-metal stimulus.  And low inflation rates would give the doves a basis for tightening ever so gently--and patiently.

So, if you're dreaming of higher interest rates, dream on.  When you wake up, you'll find that our low inflation reality means it was just a dream.

Fed Guidance in a Fog

The terrain is getting foggier and foggier for the Federal Reserve.  Most recently, GDP barely grew (at an annual rate of 0.1% for the first quarter of 2014).  But nonfarm employment grew by 288,000 jobs in April, a pretty good pace.  And the unemployment rate dropped to 6.3%.  Not that many Fed Open Market Committee meetings ago, an unemployment level of 6.3% would have been below the point where the Fed's guidance dictated a rise in short term interest rates.  But rising rates would make the stock market pout and sulk.  So the Fed has backed away from firm benchmarks for monetary policy and is electrically sliding its way toward a strictly "data-based" policy.  What does that mean?  Apparently, it means whatever the Fed thinks the data indicates it should do in order to promote full employment. But if the data is becoming less clear, then what?

For more than a decade, the Fed has worked to provide greater transparency.  That's perceived to be a good thing because it tells the financial markets what to expect.  Presumably, investors will make wiser decisions if they better understand the lay of the land.  But transparency also encourages risk-taking.  If you know what the central bank will do, you can layer on more speculative bets because one factor that might blow you up now seems predictable.  This perhaps unintended consequence of transparency tends to lock the Fed into its guidance, and limit its options, because if you do something other than what you say, all the hedge funds, big banks and other speculators might get hosed.  And then the specter of a systemic tummy ache would loom. 

With the data getting murkier as the economy recovery sputters along, the Fed has become less transparent.  Most likely, this isn't accidental, as the Open Market Committee no doubt can see that the data is telling them less and less, and benchmarks don't mean what they used to mean.  The gamblers in the stock markets can't be happy, as the odds have become harder to calculate.  Fed policy now depends on the data, and recent data resembles a pushmi-pullyu.  

The Fed still hums the low interest rate melody even though it doesn't sing the lyrics any more.  That's a pretty good pacifier for the stock market, at least for now.  But with foreign affairs descending into the mosh pit (who wants to bet Vlad the Invader won't strike again?), and the economic recovery constantly shifting back and forth between first and second gears, the data--and consequently the Fed's guidance--will probably get foggier.

Beginning the Taper: What Fed Policy Change?

The Federal Reserve announced today that it will begin to taper its purchases of Treasury securities and mortgage-backed securities.  Starting in January, it will purchase each month $40 billion of Treasuries and $35 billion of mortgage-backs, instead of $45 billion and $40 billion, respectively.  A $10 billion drop from $85 billion per month. Whoop-de-do.  That's barely a drop in the bucket.  Yet, after the announcement, the Dow Jones Industrial Average jumped almost 300 points.  A 1.84% increase in the Dow because of a reduction in central bank accommodation?  Financial news stories attributed the stock market rise to a belief that the Fed was signalling that the economy was improving faster than expected.  But there's a much simpler explanation for the exuberance in stocks.

The Fed said that it was likely to keep short term interest rates at zero for "well past" the time when unemployment fell below 6.5%, its previously announced benchmark for starting to raise short term rates.  This is a significant change from previous statements.  It means that the Fed will keep short term rates at zero for a really long time, and it's not saying how long.  Could be forever, since the Fed didn't announce a new unemployment benchmark for raising rates. 

The promise of ultra cheap money indefinitely is to stocks like pouring gasoline onto a fire--instant exuberance.  What the Fed did today was give back with the right hand what it took with the left, and then some.  It's fair to say that the Fed increased net central bank intervention today.  The sharp jump in stocks is consistent with that view.  The relatively minor change in bonds is as well.

But are we surprised?  Did we really think the Fed was going to step out of the picture in a meaningful way?  American businesses and investors have become addicted to heavy doses of monetary methadone from the central bank.  If the Fed began to actually step back, the market would have tanked. 

What happened today is the Fed switched from wearing a blue tie to a paisley tie.  But the change was cosmetic, and net result was more Fed accommodation.  Oh, well. Plus ca change, plus c'est la meme chose.

From the Fed: Short Term Gain, Long Term Pain

As the Fed's ultra low interest rate policies grind on for a fifth year, we can see ever more clearly that there is no such thing as a free lunch, even when it comes to central bank policies.  The benefits of the Fed's low interest rate policies were easy to see at first:  cheap credit, stimulus to housing, a boost to the economy.  The costs didn't seem so great. 

However, by persistently favoring borrowers and heaping mulch on income-seeking investors for five years, the long term costs of the Fed's policies are emerging--and painfully so.  Detroit is in bankruptcy, and other cities teeter on the brink. Corporate defined benefit pension plans are becoming less common than the ivory-billed woodpecker. It's no wonder why.  Pension funds rely on safe long term investments that provide solid returns.  U.S. Treasury notes and bonds used to be crucially important components of pension fund portfolios.  AAA-rated corporates, which would have to pay slightly better than Treasuries, also were favored investments.  But pension plan returns came under stress as the returns on these low-risk investments nosedived.  And pension fund deficiencies, calculated on the basis of long term returns, balloon when returns fall.  Plan sponsors have to increase contributions--sometimes enormously--to keep the plans solvent.  Corporate executives intent on making the big score with their stock options see little upside to signing off on these contributions.  Shrinking cities like Detroit have little ability to make them.  Something has to give, and pensioners seem to be doing a lot of giving these days.  Detroit's problems go well beyond low long term interest rates.  But the city really didn't need the Fed to push it closer to the abyss. 

Neither did a lot of corporate employees whose retirements are less secure after losing their defined benefit pensions or seeing the plans capped.  Most people aren't skilled at managing their finances.  When fewer have defined benefit pensions, more are likely to end up with just Social Security, even if they start retirement with good-sized 401(k) account balances.  When people have fewer or no private resources, cutting benefits from the government becomes political anathema. 

Low interest rates hurt older folks in other ways.  As income from their interest-bearing investments dries up, fear drives them to become serial economizers.  That's a hard habit to break even after rates rise again (assuming they do).  Consumption may be impaired for a long time.  In addition, long term care insurance is getting scarce and expensive.  While poorly conceived estimates by insurers of the cost of care have much to do with that, the inability of insurers to obtain decent, safe returns on investments has added to the problem.  Fewer people are able to afford such policies.  So we have a ticking demographic time bomb, with lots of uninsured elderly likely to need Medicaid in a decade or two or three instead of being able to rely on their own resources.  Low interest rates are beneficial to the federal government's borrowing costs right now, keeping the budget deficit lower.  But positioning a lot of people to need Medicaid in decades to come means we'll have pressure toward an increased deficit in the long term.

 The Fed is taking a page from corporate America:  focus on short term returns at the risk of increasing long term costs.  The great corporate success stories don't follow this plot line.  But there's not much chance the narrative will change.  The Fed's easy money merry-go-round keeps the stock market buoyant.  With mid-term Congressional elections coming up next year, the Obama administration needs to keep the market feeling chipper.  Ultimately, everything in Washington happens for political reasons.  And politics dictates that Janet Yellen, a monetary dove, will be Obama's nominee as the next Chairman of the Fed.