The Fallout From a Frozen Fed (Michael Pento)

Euro Pacific Capital
By: Michael Pento
August 10, 2011

The Federal Reserve ventured into unchartered territory yesterday when announcing that the target for the Federal Funds rate would remain near zero percent for two additional years. That will amount to be, at a minimum, four and a half years in duration. But the move is exactly the wrong strategy and does nothing to heal the structural problems of the economy.

The market rebounded sharply yesterday on the back of the promise of free money in perpetuity. However, it will soon be surprised at how little Bernanke’s largess goes towards rectifying our problems. Zero percent interest rates can’t make European debt solvent. And two more years of free money won’t automatically repair America’s severely damaged public and private sector balance sheets.

Let’s be honest, nobody was expecting the Fed to significantly tighten monetary policy in the near future anyway. Therefore, providing a definite time frame of two years does not add much additional information because it isn’t far off from what most in the investment community had been expecting--especially in light of the recent weakening economic data.

But by punishing savers for a couple more years, it will only decrease the money available to create capital goods and only encourage reckless speculation in high-risk assets and the perpetuation of rolling asset bubbles.

What is also likely to occur will be the economy to become completely addicted to artificially-produced low interest rates. Banks borrow short and lend long and are very susceptible to interest rate shocks, just as occurred during the savings and loan crisis in the 80’s and early 90’s and the credit crisis of 2008. Banks’ assets will be collecting interest on low-yielding, long-term loans that will have been prevalent in the economy for over four years. Those interest rates are now about 500 basis points below the average going back to 1970.

But interest rates must soon significantly rise either due to the overwhelming supply issuance of Treasuries in the pipeline or through the inflation that always occurs from free money and a $2.9 trillion Fed balance sheet. Once rates rise, depositors will earn more than banks’ assets collect, and insolvency will result. Not only will banks' balance sheets be under stress but also the consumer and the government are in for a massive interest rate shock coming from skyrocketing debt service payments.

Years more of free money will result in tremendous economic imbalances, a crumbling currency, rising commodity prices and a ridiculously out of control bond market bubble. And that cannot at all end well.

Michael Pento, Senior Economist at Euro Pacific Capital is a well-established specialist in the “Austrian School” of economics. He is a regular guest on CNBC, Bloomberg, Fox Business, and other national media outlets and his market analysis can be read in most major financial publications, including the Wall Street Journal. Prior to joining Euro Pacific, Michael worked for a boutique investment advisory firm to create ETFs and UITs that were sold throughout Wall Street. Earlier in his career, he worked on the floor of the NYSE.