The Federal Reserve’s easy money policy has been keeping interest rates below the long-term expected rate of inflation. Many see this as a big plus for Americans struggling to survive the down economy, particularly those who wish to purchase or refinance a home. There are many reasons why this is simply not true, one of which I’ll focus on here.
We always purchase more of something that we otherwise would when we don’t have to pay full price. Artificially low interest rates allow homeowners to purchase a house below market price. Visit www.mortgagecalculator.org and you’ll see that the monthly payment for a 30-year. $250,000 mortgage at a 5% fixed rate (not including property taxes or PMI) is $1342. Raise the rate to 6% and the payment climbs to $1499. In order to keep the payment at the same level, you must must cut your mortgage by about 11%. Put another way, if the Fed keeps your mortgage rate 1% lower than the market would otherwise charge, then about 11% of your mortgage is being subsidized by a depreciating dollar. But this is not as innocent as it sounds.
First, there is no such thing as a free lunch. In fact, the subsidy is being financed indirectly through a weaker dollar. Whether it’s the cash in your wallet or your 401(k), each dollar you have declines in value to balance the system. In essence, those of us with any accumulated wealth are paying part of the interest. (A weaker dollar also drives up oil prices, as previously addressed on the blog).
Second, there is also a problem when people buy more house than they can afford, as the recent housing meltdown should remind us. When we create an excess of supply, prices rise in the short term because of the temporary shortage and then plummet when an economic shock hits and the oversupply is too much to hide. By encouraging Americans to buy more expensive homes than they can really afford, the Fed is blowing up the next housing bubble.
Third, in a free economy–one without a Federal Reserve controlling the price of money–interest rates rise and fall to maintain a balance between legitimate demand for capital and funds available in the private sector. When the Fed keeps rates too low, the demand for borrowed funds is higher than the supply available to fulfill it. By augmenting funds in the private sector, the Fed is pushing more money into the system than the private sector can support over the long term. This surplus is what some economists call malinvestment because it represents riskier loans that should never have been made.
Finally, artificially low interest rates drive down the returns on savings. As a result, Americans with extra dollars can’t even keep up with inflation without putting their money at risk, usually in the stock market. Those on fixed incomes or living on savings suffer the most as purchasing power is extracted from their monthly checks.
We’ve been told that easing will continue, but it’s time that we realize the cost we pay for this intervention, as individuals and as a society..