Equity investors are euphoric about the Federal Reserve’s expected move to lower interest rates, after its four small increases in 2018. However, rates are still far below normal levels, so this move would create serious problems for government policy and investor choice.
By keeping interest rates so low for so long, the Federal Reserve is losing its best monetary tool for fighting the next recession, and implicitly undermining Congressional efforts to constrain spending and preserve fiscal firepower. During this extended period, the Fed’s suppression of interest rates is also taking a heavy toll on bond investors: They can’t find relatively safe bonds with reasonable yields, so they are reaching for higher yields by buying very risky bonds.
When the U.S. economy falls into the next recession, as it inevitably must, the Federal Reserve needs to respond by sharply lowering interest rates. This is the main monetary tool the Fed has to push the economy back into a growth mode. However, U.S. interest rates are now so low that the Fed has little dry powder in its arsenal. For example, rates on 10-year U.S. Treasury bonds have dropped to 2%, as compared to a 5% average before the last financial crisis in 2008.