What is a Zero Interest Rate Policy (also known as ZIRP)?
The definition is as follows: The lowest percentage of owed principal that a central bank can set. In monetary policy, the use of a zero percent nominal interest rate means that the bank can no longer reduce the interest rate to encourage economic growth. As the interest rate approaches zero, the effectiveness of monetary policy is reduced as a macroeconomic tool.
Is ZIRP good or bad or both?
ZIRP is good. It stimulates business investment. ZIRP enables consumers to better finance expensive items such as cars, boats and homes. It creates more demand for goods and services which creates earnings for companies and the need to hire employees and lower unemployment.
Or maybe ZIRP is bad. ZIRP provides poorly run banks with reserves at a low cost, enabling them to avoid failure and continue with policies that are damaging and should be abandoned. It robs responsible savers from the interest they should be earning in their savings accounts and forces them to take more risk to get returns that can provide a decent lifestyle. ZIRP also creates inflation, so while earning nothing at the bank, the cost of goods and services rise. ZIRP encourages government borrowing, spending and expansion.
According to the U.S. Government Accountability Office, in 2008, the federal government reported a net interest expense of about $220 billion. In 2011, they reported $220 billion in net interest expense again. One might think the government accomplished something by keeping the expense at the same level, but what they have really done is create negative leverage that one day we will pay for. Interest rates plummeted between 2008 and 2011 but the expense stayed the same, therefore the amount of debt grew substantially. If rates rise to 4 or 5 percent and our debt grows at historical norms, we will nearly triple our interest expense to $600 billion or more. That is almost 25 percent of the total receipts the federal government expects for 2012. How about the idea of rates going back to levels we saw in the early '80s? The debt service would exceed the total federal receipts. That is scary.
So, ZIRP is both good and bad.
Now that we know ZIRP is both, and the Fed has announced that the policy will continue at least through 2014, what do we do to prepare?
For starters, one should restructure mortgage debt (on properties you intend to hold long term) to a fixed rate. Adjustable-rate loans could prove to be dangerous. Analyze your investment holdings. As interest rates rise, high-quality long-term bonds will be subject to interest rate risk and could experience severe losses. The investments that have been our favorites for the last decade can quickly become our dogs.
Equally scrutinize your retirement plans at work. Often times, we overlook these accounts. Consider very low duration bonds or secure collateralized debt that adjusts as rates rise. Ask yourself, "Have I accumulated enough to satisfy my lifestyle in retirement?" If the answer is yes, strongly consider being less aggressive or hedging against market losses. No need to take undue risks.
We know the rates cannot go down further, but we do not know when they are going up. Currently, the Fed is borrowing money and buying bonds to keep the rates down. This policy cannot continue for the long term and when it stops, rates will go up and may rise substantially. Be sure to prepare your family for the coming economic environment.
Michael Patrick Jacobs, CFP?, is a Partner at Alexandria, VA-based Monument Wealth Management, a full service wealth management firm located in the Washington, DC area. Mike and the rest of the Monument Wealth Management team can be followed on their blog at "Off The Wall", on Twitter @MonumentWealth, and on their Facebook page.
More From US News & World Report
- The Financial Risks of Getting Older
- Is Warren Buffett Wrong on Stocks?
- Tax Time 2012: Changes You Need to Know
- Investment & Company Information
- Interest rates
- nominal interest rate