Why the Fed's recent move is so important

Let me give a quick and dirty explanation of Fed policy.  When times are good, the Fed raises interest rates to keep growth and inflation under control.  Because when the economy grows very fast, businesses expand rapidly into new endeavors, bid prices up high, and hire workers.  But this gets to be too much of a good thing when people overbuy(prices bid too high).  Overbuying is the cause of recessions.  If people overbuy houses (2006) the becomes a bubble, the market collapses and a recession results. On the other hand, when the economy is bad, interest rates are lowered to encourage businesses by lowering their borrowing costs.  That’s what Fed does in a recession. 

Now if times are so-so and inflation has met your goals of under 2%, you can use interest rate policy to help the labor market.  If unemployment is high, the Fed will keep interest rates low, reducing business borrowing costs and this frees up money to hire workers. Businesses can hire on the cheap so low interest stimulates the economy without making it overheat and form asset bubbles.  But when unemployment is low, you want to raise interest rates, because keeping interest low for too long a time encourages asset bubbles occur.  That’s where investors see the economy right now. 

Currently, the Fed is in a quandry.  The international economy is poor.  US growth, despite how politicians want to spin it, is crappy. So there are mixed signals and the Fed decided not to raise interest which is now zero percent for interbank loans.

Investors were shocked.  They thought the Fed would raise interest.  Either the Fed is seeing the world differently or something else is going on.  Hence the day after the Fed decision, the stock market was down almost 2% and not just in USA but all over the world.  Investors worry that the world’s economy is crappier than they thought. Moreover, if an asset bubble develops and the interest rate is zero, that interest rate can’t go any lower.  The Fed has no tool to fight recession.

But this is nothing new.  Japan has been in this situation for over 20 years.  Interest is zilch and creates periodic asset bubbles and recessions.  But then recovery growth is paltry and attempts to raise interest cause bad things for their economy.  It’s called a Liquidity Trap. Now think about what this does to average Joe investor who is retired and needs some income to live on.  Bank CDs are just a percent and bonds are 2 or 3. He’s tempted to invest in stocks but he might very well lose a lot of it because of risk. There’s no good solution.

So where does the Liquidity Trap come from?  It’s too much regulation of business or some other control that causes business to play it very safe.  The economy refuses to grow. Central Banks (Fed) respond with low interest but it doesn’t help. Slouching into socialism, the country lapses into a no-growth economy.  Only if the country doing this is undeveloped and can borrow manufacturing and services ideas that have already been developed, can good growth occur. 

What happens if the entire developed world has a liquidity trap?  That’s the question today and the results may not be happy for established nations.  And concerning seniors who need income from investments, it means you have to find another source of cash flow.