Why 0% is Bad

In what is less and less of a news item, the Fed kept interest rates at 0% today. No change since December '08. No sign of tightening on the horizon.

So long as the economy remains deflationary in most sectors, particularly jobs and housing, in keeping with the Fed's mandate for price stability (yeah it is hard to keep a straight face while writing that), there is little alternative other than to keep rates at 0%.

So what is wrong then, in a deflationary environment, with just handing out money with the sole condition that the borrower has to pay it back, absent any interest? The problem is, it hurts all investments in the long run.

It directly hurts cash and treasury bonds, in terms of reducing interest payments there. But it indirectly hurts stocks as well. With interest rates on cash and bonds generally low in the 0-2% range, stock dividends no longer have to be as much to still be attractive investments. Price-earnings ratios for stocks can go way down and still be competitive in the 2-3% range, which drives the prices of stocks higher. Say a stock pays 50 cents in dividends per share per year. If you are looking for a return of 6%, each share would have to be priced at around $9 to be of interest. But in a climate where 3% is considered a competitive return, then the stock should sell okay at $17.50. The DJIA going up absent higher dividends simply means investors are willing to accept lower P/E ratios.

Now, if an investment bank can borrow money from the Fed at close to 0%, and invest it with a 3% return, well that is a good deal for doing no work and producing nothing of value. The Fed maintaining interest rates at 0% thus insures low yields for all investements.