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The tight-rope economy

April 30, 2013

| MoneyRates.com Senior Financial Analyst, CFA

Depositors in savings accounts have been asked to sacrifice their interest rates for the sake of economic stimulus. The question is, after four year of this, when will this sacrifice be rewarded?

The answer depends on whether the economy can pull off a tricky tight-rope act. It has to lean dangerously close to speculation, and hope that economic fundamentals come through to balance the economy before it goes too far and tips over. This relates to savings accounts and other deposits, because driving bank rates down has been such a prominent part of the Federal Reserve's strategy for boosting the economy. Those low rates may also be pushing the economy further toward speculation.

Defending the Fed

Janet Yellen, Vice Chair of the Board of Governors of the Federal Reserve and someone who has been touted as a possible successor to Ben Bernanke, has defended the low-interest-rate strategy on the grounds that it has increased "interest-sensitive spending" and has boosted the values of stocks and housing.

As much as those accomplishments could help stimulate economic activity, they also represent things that are pushing the economy further over to the speculative side of the tight-rope.

A speculative tilt

The increase in "interest-sensitive spending" that Yellen cites is a polite way of saying that people are buying more with borrowed money. This increases the speculative tilt of the economy because consumer borrowing is already at a record high.

Meanwhile, the higher asset values of stocks and housing are only temporary if they are based on a temporary monetary policy. The higher those values are pushed by that policy, the more they resemble a bubble waiting to burst.

Waiting for job growth

What the Fed acknowledges to really matter in the long run is job growth. Indeed, the Fed has identified getting the unemployment rate down to 6.5 percent as a key objective of its policies, saying it is likely to keep its low-rate approach in place until that target is met.

Keying the future of its interest rate strategy to the unemployment rate is a change from the Fed's previous approach of putting a target date on when it expects to raise rates. That target date kept getting extended, most recently to mid-2015. The switch to an unemployment target means that low interest rates may continue even longer than that, if unemployment does not decline sufficiently.

Meanwhile, the longer the low-interest-rate policy is extended, the greater the risk that the resulting speculation could bring down the economy. This can be because asset bubbles eventually collapse or because consumer borrowing hits a wall, or both. Either way, the outcome of the tight-rope act depends on whether job growth can fundamentally improve the economy before that happens. That would be the best outcome for the economy -- and for CD, savings and money market rates.

In the meantime, this leaves depositors in the same position as the Fed -- watching the economy's tight-rope act while waiting for job growth.

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