In Fed Rate Cut, Bad News for Savers we discussed how the Federal Reserve’s interest rate cuts affects all Americans, but what happens if they keep cutting interest rates all the way to 0% (a.k.a. zero interest rate bound)?
Just since last September, Ben Bernanke and the Federal Reserve have cut the short-term interest rate from 5.25% to 2.25. Bloomberg calls this, “The most aggressive easing in two decades.” These rate cuts are an effort to stimulate the economy and make borrowing money easier for consumers.
But has the Fed reached a point where the rate cuts are no longer effective?
Bernanke believes that the Great Depression could have been avoided if the Fed cut rates faster and more aggressively, so economists are expecting him to keep cutting. However, there is not much more to go before we hit bottom, and nominal interest rates cannot go below zero percent.
So What Happens if the Fed Goes to a Zero-Interest-Rate Policy?
It is unlikely that the Fed will cut rates all the way to 0%, but don’t eliminate that as an option. Japan has mostly had a zero-interest-rate policy since 1999, and there is a lot we can learn from them.
Once the U.S. is zero bound, the Central Bank can no longer stimulate the economy with further interest rate cuts. As a result, they will have to turn to “non-standard” efforts, such as infusing more cash into the economy.
For those hoping mortgage rates will lower, that is not necessarily the case. In fact, so far the opposite has been true. Recently, as rates have been cut, mortgage rates have actually risen.
Rate cuts below the level of inflation will not benefit consumers. Why? The issue is that banks are not willing to lend money at a rate lower than inflation. In other words if the Fed cuts rates to 2% and the inflation rate is 4%, banks would actually lose money on loans due to inflation.
What will likely happen as we approach zero bound is the U.S. will experience a liquidity trap. Spending will be low because money is tight, and people and businesses won’t invest because there is no gain. Therefore the economy will remain stagnant as people keep money stashed away in savings rather than invested. As a result a recession will occur and banks will be unwilling to lend money.
Millionaire Money Habit: As the American economy continues to struggle and the interest rates continue to decrease, keep in mind that your savings account is not the best place for your money. It may be a safe ground, but just as banks will not lend money below inflation rates, you should have the same attitude with your money. -RT
