Fed’s Near-Zero Interest Rate Policy a Failure?

The world’s largest central banks continue to follow a low interest rate policy first implemented to deal with the 2008 recession. The argument for adopting the record-low rate was that deep cuts to the lending rate would help ensure sufficient liquidity within the financial system and encourage spending and growth promotion.

In this regard, the U.S. Federal Reserve was the most aggressive of the major central banks. After a quick succession of rate cuts, the Fed took less than a year to chop the benchmark lending rate from 5.25 percent, to a maximum of 0.25 percent as of December, 2008. Now, more than three years later, the lending rate remains zero bound; a fact that has some critics suggesting the Fed’s policy has failed to accomplish its stated goals.

One of the most vocal opponent’s of the Fed’s approach is himself a Federal Reserve Bank President. Thomas Hoenig, President of the Federal Reserve Bank of Kansas City has, on several occasions now, spoken out against the continuation of near-zero interest rates.

Referring to the current Federal Funds rate as a “subsidy” for the banking industry, it is Hoenig’s assertion that while banks are indeed taking advantage of the “cheap” money available from the Fed, funds are not being made available for commercial and retail lending. The banks are instead simply investing the cash directly into higher yielding bonds including U.S. government treasuries. As of Wednesday morning, the benchmark 10-year yield on U.S. debt was 1.82 percent.

Using money from the Fed to buy higher yielding securities may make it possible for institutions to profit on the positive interest rate carry, but does little to help businesses acquire capital to expand and help get Americans back to work. It can also be argued that this policy has actually reduced liquidity.

With the ability to profit on higher-yielding bonds as described, banks have become even more selective to whom they provide loans. Banks can simply shun all but the top-tier ventures representing the least amount of risk. The result, according to Hoenig, is that rather than encourage lending to support growth, the Fed’s policy has actually made it more difficult for smaller companies and private individuals to gain access to the Fed’s liquidity.

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