Outside the Box: Federal Reserve’s interest-rate cuts hurt the economy by tamping down lending

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If an alien with a good head for economics had landed in the United States in September as the Federal Reserve announced its second interest-rate cut of the year, you could forgive it for being bemused.

For the most part, it would see signs of a robust economy and business sector, ranging from strong consumer spending to unemployment close to historic lows. True, the manufacturing sector has been struggling, but it’s about the only weak spot in the economy.

This is not an economy in obvious need of monetary stimulus, even though it has slowed somewhat over the past year. In fact, the Fed’s policy not only seems unnecessary, but it could also end up backfiring on the economy and spurring dangerous risks down the road.

The Fed has couched its decision to cut rates by 50 basis points this year as “insurance” against growing uncertainty in the global economy, such as Brexit, U.S-China trade tensions and a gathering slowdown in Europe and Asia.

Borrowing costs not a concern

But this approach is unlikely to stimulate much new demand at home. That’s because the cost of borrowing is not a major concern for most businesses right now. Companies may be suffering from uncertainty over trade tensions or an overseas slowdown, but that doesn’t mean they are chomping at the bit for lower interest rates so that they can borrow more.

If you are a small-business owner worried about the effect of U.S. tariffs on China, a half-point difference in interest rates isn’t going to make much difference. You’re still not going to invest in an area whose profits could be wiped out. The problem for such businesses isn’t the cost of capital; it’s uncertainty.

By cutting rates, the Fed is also directly cutting the profitability of the vast majority of U.S. banks just when monetary conditions had returned to more normal levels following the 2007-2008 financial crisis. This actually could make them less willing to make loans, resulting in the exact opposite of what is intended by the policy.

Of the nearly 5,000 banks in the United States, most are under $10 billion in asset size. Most of those banks rely on the simple difference between the rate they charge for loans and the rate they pay depositors for 70%-80% of their revenue.

Collapse in spreads

That spread collapsed after the financial crisis as the Fed cut rates to zero. It started to rebound somewhat during the period when the central bank was raising rates from 2016 through 2018. This not only restored banks’ profitability closer to their historical levels, but the industry was also able to start increasing the rates they paid for their deposits, which of course benefits the consumer.

So when the Fed changed course and cut rates this year in an environment where it does not necessarily stimulate more credit generation, the banks now have a choice to make — lower profitability, decrease deposit rates or preserve profitability by turning away some loans.

This potentially leads to the other risky aspect of cutting rates when monetary policy is already accommodative. When bank profitability is reduced, banks may reach for higher returns through riskier lending and investments. We all saw how that turned out in 2007-2008.

Ammunition running low

The Federal Open Market Committee is full of smart people who may eventually be proven right to have decided to get ahead of the game in case the U.S. catches a cold from the rest of the world. But the risk is that they are using up valuable ammunition in trying to fix problems that don’t exist.

We only have to look across the Atlantic to see how lower interest rates are not always effective in stimulating an economy and can have undesirable effects. Interest rates in Europe have been negative for quite some time, meaning that depositors are paying banks to hold their money.

The idea was that this would encourage companies to invest and banks to lend money rather than stash it with the central bank. But its unintended effect has been to crimp lending by hurting the already poor financial health of the region’s banks.

The Fed should take note.

Aldis Birkans is chief financial officer at National Bank Holdings, serving clients through Bank Midwest, Community Banks of Colorado and Hillcrest Bank.