The cliché now being used that the Federal Reserve ought to “cut interest rates in take out an insurance policy to prevent a recession” is wrong. By cutting rates with an eventual move to either zero real rates or even zero nominal rates, this causes problems for both retirees, and future retirees who are saving for retirement. It causes problems for banks, insurance companies, and pension funds. At some point if rates are too low for too long then retirees will respond by cutting their standard of living, reducing consumption and this will negate the stimulus from cutting borrower’s rates. Negative or zero rates will ruin banks and insurance companies, leading to a wave of banking failures and then we would be right back to square one when Lehman went bankrupt on 9-14-2008.
The Fed’s cutting of rates forces investors to take dangerous speculative risks which in turn would lead to ruinous losses for some who were fooled by bubbles, requiring more bailouts and more stimulus. When the Fed issues newly printed money to buy bonds it takes the interest earned and donates it to the government, thus QE money printing is a deflationary activity that drains income from the private sector, and it also drains money from the pension funds of state and muni governments, and transfers it to the U.S. Treasury and is thus similar to the concept of a tax increase. Rising taxation is an anti-stimulative act to dampen economic activity by transferring money to the government from the private sector. Thus QE is actually a hidden form of taxation, not authorized by legislation.
Cutting rates doesn’t increase consumption if consumers are already overindebted. Cutting rates may not significantly reduce the burden of debt payments since as rates go lower, a greater percentage of a combined principal and interest payment goes to principal rather than interest. For a 30 year fully amortized loan, if you pay 14% almost all of it goes to interest; if you pay 3% interest then 41% of the payment goes to principal in the first month, if the rate is 2% then 55% of the first payment goes to principal. At 0% interest, the payment on a 30 year loan is 4% a year of principal and zero interest. Thus declining interest rates on fully amortized loans are not that helpful to consumers.
Artificially low rates force investors to seek fake “yield” by issuing put options or similar risky schemes. The problem is that if stocks are overpriced and due for a 50% drop then the naïve issuers of puts will lose 50% just to get a “yield” of less than 10%.
Junk bonds may offer a high yield but if in the next recession they repeat the price drop of 43% that they had in 2008, then junk bond investors will suffer a similar fate as the issuers of puts that is of greater impact than the high yields.
Investors need independent financial advice about the risks of a return to QE and negative interest rates.