How The Fed Kills The Credit Markets With Ultra-Low Rates. - Page 2
With short term rates near zero, that brings real interest rates, which are the nominal rate less inflation, into negative territory. With CPI inflation at 1.1% and short term rates near zero, that leaves real rates near -1%. While I am not smart enough to know what the true market rate would be, I can tell you that negative real interest rates are nothing healthy. They have typically only existed in high inflationary times like the late 70s early 80s. Now negative real interest rates are back. They are not back because inflation is too high. They are back because nominal interest rates are too low.
Negative real rates and nominal rates near zero give an open invitation for other countries to start using our currency as the patsy. Hence, the carry trade is alive and well with companies and hedge funds borrowing in the US and funding their investments overseas. Japan tried the negative real interest rates for years to get their economy going with little to show in terms of domestic growth.
What should rates be?
My view is that short term rates should be closer to 2%. I'm not Mr. Market so I can't give the exact number. KC Fed chief and long-time critic of the current policy has called for the Fed to reset the short term rates to 1%. Economist Steve Hanke of John's Hopkins suggested 2%. I think even 1% is low because that still doesn't bring the real cost of money above zero.
That brings cash onto the balance sheets of banks. That leads me to one of the misconceptions in this crisis. Banks are not just sitting on a ton of cash, they are also sitting on a ton of potential bad debts. They are not cash rich, they are cash poor.
The effect of raising rates brings the real interest rate above zero and actually incentivizes people to start saving again. More savings means more cash on banks' balance sheets. Not until we solve the banks' balance sheets will they be willing to invest once more.