Trapped by ZIRP

The Fed’s zero interest rate policy, aka ‘ZIRP’, was devised to turn the 2008/09 downturn from a potential depression into merely the Great Recession, and as far as anyone can tell, it worked. However, ZIRP has continued far longer than anyone thought likely.

A change from ZIRP does not necessarily mean increasing rates across the board. It will mean short rates will rise, when and if the Fed finally acts. We call that ‘normalization’ these days, since zero as a rate is abnormal. The question is when is the Fed going to act. The past couple of years have offered many opportunities but none has been quite good enough, apparently.

This last time around, the Fed held up because the global economy looks as though it is weakening. Worse yet, third quarter earnings reports look paltry, and layoff announcements are increasing in the US. This could amount to a mere slowdown or it could mean a shallow recession. If enough such signs proliferate, we expect ZIRP to persist into 2016. It’s not that 25 basis points makes that much difference. It’s that once the Fed hikes, the next topic of speculation will be when will it happen again – another element of uncertainty. The mere fact that investors are so focused on ‘will they, won’t they’ tells us that there isn’t enough else that is good about the economy.

What if ZIRP itself is causing the slowdown at this point? ZIRP has led to overcapacity in many industries, and now it is braking the process of correcting those bubbles, which is deflating many commodity prices. And low interest rates have not helped much to reduce household or other indebtedness in the US; in fact, ZIRP is akin to solving a borrowing crisis by spurring more borrowing. Student loan debt, subprime auto loans, energy company debt – there’s a lot of it. Economies expand when borrowing starts from a low base, but we are already at a very high base. There aren’t many people left who need to, want to, or even can borrow.

So while ZIRP has undesirable elements, we may be stuck with it for a while, because the cost of a hike is growing by the day.