by Mitch Kokai
Senior Political Analyst, John Locke Foundation
The increased risk taking created by the Fed’s policy of exceptionally low interest rates involves lenders as well as investors. To maintain their prof-its, banks and other lenders are extending credit to high-risk borrowers, including those who already owe substantial amounts of debt. And the terms of recent bank loans are more lenient, with so-called covenant-lite loans imposing fewer requirements on borrowers and therefore providing less protection to the lenders. …
… The Fed is pursuing its strategy of very low in-terest rates for two reasons. First, it would like to increase demand in order to reduce the current low unemployment rate even more. While there is no doubt that there are people who would like to work full time but cannot find a job, the Fed’s goal of an unemployment rate below 5% is unsustainable and will lead to more rapidly rising inflation. Second, the Fed fears that the financial markets will react to rising short-term rates by pushing up longer-term rates, widening credit spreads and reducing equity values. That in turn could destabilize the economy.
The danger, though, is that by waiting, the Fed will be forced by the arrival of higher inflation rates to raise the federal-funds rate more rapidly than it and the financial markets now anticipate, causing greater instability in bond and equity markets with adverse effects on the real economy.
The Fed’s hope to return interest rates to tradi-tional levels without destabilizing the economy is an understandable goal, but it may not be an achievable one. The Fed used the unconventional monetary policy of exceptionally low interest rates for an extended period of time to cure a very deep recession. It succeeded in doing that, but the coun-try may have to pay a price for this extreme policy. Only time will tell.