American Central Bank Seen Reinflating Financial Bubble

By keeping interest rates near zero, the Federal Reserve is distorting investment.

Fear is rising that the American central bank’s expansionary monetary policy might be inflating another bubble. Having flooded financial markets with some $2 trillion in easy money since the summer of 2007, the Federal Reserve has hampered a necessary reallocation of resources that would have benefited the American economy as a whole in favor of propping up the baking industry.

Late last year, the central bank announced that it would continue to keep interest rates near zero and pump money into the economy as long as it takes for unemployment to come down to 6.5 percent. It stood at 7.6 percent in March, having slowly dropped from a 10 percent high since October 2009.

Yet five years into the Fed’s monetary policy experiment, millions of Americans remain out of work. ProRepublica‘s Jesse Eisinger pointed out in The New York Times last month that in March, “a smaller percentage of working age people were actually working than at any other time since 1979.”

Rather than fuel a sustainable economy recovery, he argued, “the Fed has kindled speculation. Investors are desperate for yield and are paying up for riskier assets. In areas like real estate, structured finance and equities, the markets are ahead of the fundamentals.”

Quartz‘s Simone Foxman similarly reported on Monday that even the central bank itself is starting to worry about asset bubbles. Federal Reserve chairman Ben Bernanke said last week that he was “watching particularly closely for instances of ‘reaching for yield’ and other forms of excessive risk taking which may affect asset prices and their relationships with fundamentals.”

The problem, according to Foxman, is that it’s “hard to know what ‘excessive risk taking’ would look like these days because the central banks’ involvement in the markets is distorting the usual ways risk is measured.”

Detlev Schlichter, a former investment manager and author of Paper Money Collapse (2011), therefore likened the Fed’s policy last year to a giant placebo. “It is not true medication as it evidently does not address the economy’s fundamental ills but a tool for nationwide mass hypnosis,” he wrote at his blog. It does so by driving down interest rates and cajoling investors into economic activity.

Low interest rates should signal “the availability of a large pool of voluntary savings that desires to be invested and to be translated into productive assets,” Schlichter explained. By printing new money and keeping interest rates near zero, the Federal Reserve hopes to encourage such investment in the absence of savings.

In doing so, it has certainly “sabotaged the redirection of scarce capital from the bubble industries that had benefited from the credit boom toward new, productive and more sustainable employment in other sectors” and might even be setting the stage for another crisis.