The Fed cut the federal funds rate by 50 basis points last week, to 1.0%. In doing so, Bernanke has taken the rate right back to 2003 levels, when Greenspan also had the rate at 1.0%. Unfortunately, the Consumer price Index data released in September showed year over year inflation of 4.9%. This means that real interest rates are negative at the present time, and that was exactly what created the commodities and property boom and bust of 2003-7. This approach is a return to the status quo of the last few years and like trying to cure a hangover with another drink. So why does it matter if real rates are negative?
Consider the following formula: Nominal Interest Rate = Real Interest Rate + Inflation.
Therefore, the Real Interest Rate = the Nominal Interest Rate - Inflation.
If inflation is higher than the nominal interest rate, clearly the real interest rate is negative. Recently the rate of inflation exceeded 4.0%. This means real rates are less than -3.0%.
In this context, why would anyone save money when their returns are not keeping pace with inflation? Negative real rates are possible in a deflationary economy, where the rate of deflation exceeds the negative interest rate (think Japan in the late 1990's). In that context, the real interest rate would still be positive. But at the current federal funds rate of 1.0%, inflation would have to drop another 3.0% to get to a zero real interest rate. Of course lowering rates lowers the dollar against other currencies, although most other central banks are also cutting rates now.
Generally, negative real rates are unsustainable for any extended period, unless the economy is experiencing deflation. When inflation is positive, they are a subsidy; i.e., they are below what a "real" market rate would be. Where does the money for the subsidy come from? Eventually, it comes from the taxpayers, collectively, in the form of government borrowing.
What's the logic? An AP story said "The Fed action was designed to lower borrowing costs and boost spending by consumers and businesses and thus increase economic activity." No doubt, it is also designed to ease margins for financial institutions.
But a significant problem with negative real rates is that money will move out of markets where rates are negative, as investors will lose purchasing power there. It will move to markets which offer higher real rates; in other words, capital flight. Those markets could include the EU, where the ECB's key rate is 3.75%, or Australia where the central bank key rate is 5.5%.
I think the better strategy for the government would have been to allow the recession of the early 2000's to run its course, not to inflate our way out of it. But that is a done deal. And it seems the strategy is in vogue again. But at some point, it is better to deal with things head on. And with the federal funds rate at 1.0%, the Fed has precious little room left to cut if more problems arise. In that case, we may not be able to inflate our way out of this recession, and another strategy might be needed.
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