Saturday, February 11, 2012

Extended Low Interest Rates - Another Bubble or Deflation?

In January 2012, the Fed announced that it would maintain near zero interest rates until 2014. So how will low interest rates affect the economy.  There are two possible scenarios based on recent history
  1. Bubble. The first scenario is a repeat of what has already happened in the U.S. When the Fed began by lowering interest for Y2K, the economy experienced a tech stock market bubble and then a housing market bubble.  Based on this experience,  the current low interest rates could be expected to lead to another bubble.
  2. Deflation.  The second scenario is a repeat of what happened Japan. Despite the reduction of interest rates by the Bank of Japan, people didn't spend more nor did banks lend more.  Thus, there was reduction in the velocity of money and a contraction in the money supply.
I'm torn between the two scenarios.  While low interest rates have led to asset bubbles previously, credit is very tight despite the low interest rates.  And the average consumer is saving more instead of spending more. At this point, a good hedge would be to own commodities/hard assets and cash.  That way one could benefit from either scenario :-)
For more on Reflections and Musings, check back every Saturday for a new segment. 

This is not financial advice. Please consult a professional advisor.

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