Some analysts argue that the US economy is strong enough to handle some
rate-hiking by the Fed. Others argue that with the economy growing slowly the
Fed should err on the side of caution and continue to postpone its next rate
hike. Still others argue that the economy is so weak that the Fed not only
shouldn’t hike its targeted interest rate, it should be seriously considering
a rate CUT and other stimulus measures. All of these arguments are based on a
false premise.
The false premise is that the economy is boosted by forcing interest rates
to be lower than they would otherwise be. It should be obvious — although
apparently it isn’t — that an economy can’t be helped by falsifying the most
important of all price signals.
When a central bank intervenes to make interest rates lower than they
would be in a free market, a number of things happen and none of these things
are beneficial to the overall economy.
First, there will be a forced wealth transfer from savers to borrowers,
leading to less saving. To understand why this is an economic problem in
addition to being an ethical problem, think of savings as the economy’s seed
corn. Consume enough of the seed corn and there will be no future crop.
Second, construction, mining and other projects that would not be economically
viable in a less artificial monetary environment are temporarily made to look
viable. A result is that a lot of real resources are directed towards
projects that end up failing.
Third, investors seeking an income stream are forced to take bigger risks
to meet their requirements and/or obligations. In effect, conservative
investors are forced to become aggressive speculators. This inevitably leads
to massive and widespread losses down the track.
Fourth, debt becomes irresistibly attractive and starts being used in
counter-productive ways. The best example from the recent past is the trend
of US corporations taking-on increasing amounts of debt for the sole purpose
of buying back their own equity. Going down this path is a much quicker way
of boosting earnings per share than investing in the growth of the business,
so, naturally, the increasing popularity of debt-financed share buy-backs has
gone hand-in-hand with reduced capital spending.
Fifth, “defined benefit” pension funds end up with huge deficits.
The reality is that the economy cannot possibly be helped by centrally
forcing interest rates to be either lower or higher than they would be if
‘the market’ were allowed to work. The whole debate about whether the US
economy is strong enough to handle another Fed rate hike is therefore off
base.
The right question is: How much more of the Fed’s interest-rate
manipulation can the US economy tolerate?
