Currently, interest rates are extremely low, and we know that they are being kept artificially low by the policies implemented by the Federal Reserve. In fact, the Fed is subsidizing the cost of money, or put in another way, the Fed has started a welfare program that benefits those with the need to borrow money. Just like a poor person may receive food stamps from the government, the Fed is doing the same—but rather than passing out food stamps—they are lowering the cost of money to benefit a few.
Who would have believed that the Fed was going to begin a new welfare program?
Just as with most things in life, there are those who benefit from this largesse, and there are those who pay, or will pay, for the cost of financing it. Who will pay, and when will they begin paying?
The Cost of Money Explained
First, let me explain how the cost of money is determined by using the ten year Treasury bond as an example. Let’s assume that we live in an ideal world, where everybody is nice to each other, there are no wars, and there is no inflation. There is, however, a scarcity of goods and services, just as we experience in real life, and thus, there is not enough money for all who want it. Therefore, we have to ration it. In a capitalist economy, we use the price system to allocate scarce goods. It is generally accepted that money should cost about 2% to 3% in this ideal world.
But, we don’t live in an ideal world. There is such a thing as inflation. This reduces the purchasing power of money, so if you were to buy a ten year Treasury bond, you would want the return of your purchasing power at the end of the ten years. Because bonds have a fixed maturity value, the way to compensate for expected inflation, is to give you an extra return. In the US, given that inflation has historically averaged about 3%, you would want the ten year bond to pay for this too.
What about time? Giving up your money for ten years is already a penalty, because you can’t spend it today. So, you will want to be compensated for this. Let’s add another 1% to the cost of money for lending it for ten years.
There are other factors that affect the cost of money, but let’s just stop here for simplicity purposes. Now let’s add each of the components: 2% for the real cost of money, 3% for inflation and 1% for time. This adds up to 6%. That’s what the ten year Treasury bond should be paying, but it is only paying 1.98% today. Why such a huge disparity between what it should be costing and what it is costing? The Fed’s welfare program is the answer.
The Federal Reserve’s Program: Welfare or Subsidy?
A few years ago the Fed began a welfare program for those who can borrow money. Borrowers should be paying 6%, but they are only paying 2%, thanks to this new giveaway program. Whereas the taxpayer pays for the food stamp program, which the poor receive, who is paying for the welfare program that the Fed has begun? Nobody yet, but guess who will? Those who are not taking advantage of the Fed’s giveaway program.
Welfare programs, or if you prefer the more politically acceptable term subsidy programs, are costly. The Fed, at some point, will have to stop subsidizing the cost of money, and therein lies the danger. What do you think is pushing up stock prices, car sales and real estate prices today? The Fed’s welfare program. And when it stops, what will happen?
My Advice to You?
If you haven’t gotten your piece of the Fed’s welfare program, do it quickly because it will have to come to an end soon. The Fed is making it possible for you to borrow mortgages at 3.5% and car loans at even less–2.5%, when the real cost of this money should be around 7.5%.
Subsidies are not good economic policy, nor are they good financial policy. Many will pay the price soon for this folly, but you can avoid the cost and reap the benefit. Go into debt but only if it’s at fixed rate, never a variable one. And don’t get excited about stock and real estate prices today because these are being propped up by the Fe’s welfare program.
If you want to meet with me to review your personal finances, just reply to this email or call me directly at 714.771.6000