Fed Action. Helping or Hurting?

Charged with the duty of encouraging employment, the Federal Reserve has implemented aggressive monetary measures.  Expanding the Fed's balance sheet by nearly 3 trillion dollars via the purchases of an array of debt instruments, Bernanke and company have used traditional monetary tools, and some not so traditional measures, to meet the challenges of its employment mandate.

The impact has been paltry and disappointing.  For, as Newton stated, for every action, there is an equal and opposite re-action.  This holds true in the current interest rate environment as set by the Federal Reserve.

Some of these old monetary measures now utilized by the Fed could indeed have had a greater impact if we still had a large manufacturing base.  But we have lost much of that manufacturing to China and elsewhere.  We are left with a "service-based" economy.  So what impact do these Federal Reserve actions have on a "service-based" economy?  And what effect on governmental borrowing levels?  Apparently, there are effects of an adverse and unintended nature.  And here are some of those "equal and opposite" effects.

The Federal Reserve has set interest rates at what arguably are three percentage points too low.  Historically short rates on Treasuries would yield enough to cover the inflation rate, currently circa 2%, plus an additional few points.  The identifiable "false" rates obfuscate the asset evaluations and loan activity across the board.  Speculation becomes one of the avenues to obtain a "fair" yield on one's money.  And the low rates spur this activity in an environment where asset evaluations are false due to the false rates.  What would gold be worth if three-month Treasuries were at 3%?  What would 2% dividend yielding stocks be worth?

Additionally, lenders are hesitant and reluctant to loan at rates set artificially low.  Perhaps more damaging is that the government debt is serviced at rates "too low"...so low that normal market forces cannot take into account the massive supply-creation which normally would lead to higher rates, which would resultantly curb further deficit spending.  Bernanke has become the "enabler" for fiscal irresponsibility.

As for the service economy and its lifeblood, disposable income: much of disposable income is generated by return on invested dollars.  And to a service economy, this money sustains various industries that have been victims of the Fed policy...house remodeling, restaurants, recreation, hotels, and other sectors.  When this "fair return" on money is not in the hands of the service economy consumer, that vast segment of our economy suffers. 

These false rates tend to force people, banks, and businesses to "sit" on their money.  This drives the "velocity of money" down, as noted by this St. Louis Federal Reserve Bank chart.

When the velocity of money drops, the effect is to shrink monetary activity in the economy. 

These Federal Reserve-set rates have not only created false asset evaluations, but also hurt the velocity of money and the service economy, and broken the models that predict pension fund performance and goals.  The Federal Reserve must revisit its actions, because the unintended "equal and opposite" forces are too glaring to ignore.

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