Equity investors are euphoric about the Federal Reserve’s expected move to lower interest rates, after its four small increases in 2018. However, rates are still far below normal levels, so this move would create serious problems for government policy and investor choice.
By keeping interest rates so low for so long, the Federal Reserve is losing its best monetary tool for fighting the next recession, and implicitly undermining Congressional efforts to constrain spending and preserve fiscal firepower. During this extended period, the Fed’s suppression of interest rates is also taking a heavy toll on bond investors: They can’t find relatively safe bonds with reasonable yields, so they are reaching for higher yields by buying very risky bonds.
When the U.S. economy falls into the next recession, as it inevitably must, the Federal Reserve needs to respond by sharply lowering interest rates. This is the main monetary tool the Fed has to push the economy back into a growth mode. However, U.S. interest rates are now so low that the Fed has little dry powder in its arsenal. For example, rates on 10-year U.S. Treasury bonds have dropped to 2%, as compared to a 5% average before the last financial crisis in 2008.
While business executives are now worried about a possible trade war and have slowed their expansionary plans, the U.S. economy is still healthy. Unemployment is below 4%, inflation is below 2%, and consumer spending is strong. If the Federal Reserve is going to cut interest rates every time the economy becomes a little soft, what firepower will it have left for a real recession?
Moreover, the Federal Reserve’s willingness to cut interest rates implicitly discourages Congress from keeping federal budgets under control. If the Fed will come to the rescue of any economic weakness with monetary stimulus, why go through the difficult political process of reining in spending on domestic and military programs? The White House and Congress are close to agreeing on a federal budget for the next two years, which would increase spending and result in large annual deficits. By 2029, projected federal spending will bring the national debt to around 93% of our gross domestic product.
On the investor side, the Fed’s suppression of interest rates for the last decade has led to profound distortions in the securities markets. With low-risk bonds paying so little interest, investors have poured money into stocks and other risky assets—driving the price-earnings ratio of U.S. stocks to the range of 20 to 25, substantially above their historic average. The U.S. stock indexes are at all-time highs, as many tech companies (such as Uber) go public at sky-high valuations despite enormous losses.
The combination of low bond yields and high stock prices presents tough choices to many investors, especially the vast cohort of retirees and those nearing retirement. Most retirees would like to receive a steady stream of income from low-risk assets like 10-year U.S. Treasury bonds. However, even if they have built up $600,000 in their retirement account, those bonds would produce only $1,000 in monthly income at their current 2% yield. On the other hand, many of these retirees are reluctant to invest their savings in volatile stocks when they are at historic highs.
As investors have become hungrier for yield, the quality of U.S. bonds has fallen sharply. Around half of all investment-grade bonds in the U.S. now have the lowest qualifying rating of BBB. In a recession, a substantial percentage of those bonds would slip into junk status; then those bonds would no longer be eligible investments for many mutual funds and ETFs. Since the trading volume for most junk bonds is limited, these funds would suffer big losses if there were a concerted effort to sell these downgraded bonds.
Nor can U.S. investors find decent yields in sovereign bonds of stable foreign governments—which also require taking currency risk. For example, the interest rates on Japanese government bonds are generally close to zero or actually negative (they pay no interest and are sold at a price above par). In Europe, amazingly, the junk bonds of more than a dozen large companies now have negative yields. Investors are effectively paying for the privilege of holding bonds with a significant default risk.
In short, the Governors of the Federal Reserve should not cut interest rates at the first sign of an economic slowdown; rather, they should restart their 2018 efforts to bring U.S. interest rates back toward their historic averages. Such efforts will position the Federal Reserve to respond more effectively to a real recession and will allow investors to buy high-quality bonds at more reasonable yields.
Robert C. Pozen is a senior lecturer at MIT Sloan School of Management and a non-resident senior fellow at the Brookings Institution. He was formerly president of Fidelity Investments and chairman of MFS Investment Management.
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