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ALL BUSINESS: Dark side of low interest rates

Posted: Wednesday, June 25, 2003

NEW YORK (AP) Ask homeowners about lower interest rates, and you'll hear a collective cheer. Ask anyone dependent on interest income, and the boos will surely sound.

So it goes in this environment of super-low interest rates, which have been tumbling over the last two years thanks to the Federal Reserve's rate-cutting spree to recharge the economy.

Sure, much benefit has come from declining rates. But there are downsides, too.

The goal of the Fed's rate cuts is to offer cheap credit to households and businesses. That is intended to lift the economy from its three-year funk by spurring spending again.

So far, the clear winner has been the housing market, which has been booming thanks to the sharp decline in mortgage rates. Lower rates have also fueled big gains in stock and bond markets.

The business sector is picking up at a much slower pace, with companies still guarded in making big purchases of machinery or large equipment.

The federal funds rate, the interest that banks charge on overnight loans, is currently at a 41-year low of 1.25 percent after 12 rate cuts since early 2001. Another rate cut is expected when the Fed's policy-makers meet this week.

But rates so low may also have some unintended consequences that could rattle the economy.

For one, they decrease interest income that can be drawn from investments like savings accounts and certificates of deposits.

In a report earlier this month, Morgan Stanley economist Richard Berner estimated that interest income received by consumers has fallen $55 million in the last 2 1/2 years and represents 6.5 percent of personal income a 30-year low.

That's what has happened to 86-year-old Julia Work of Richland, Wash. In July, her 3-year CD with a principal of $90,000 and paying 7 percent interest will come due. It pays her about $500 a month. She's now out looking for a new CD and the best rate she's found is around 2.25 percent, which would cut her interest income to about $170 a month.

''My income will be cut down to next to nothing and I will have to cut into principal,'' Work said.

Lower interest rates could deeply hurt money-market funds by knocking down their yields to near zero, deterring new investment from consumers. And with yields so low, some funds' costs will exceed their interest income.

The industry's problems flow into the economy directly. That's because funds take much of their invested money to buy short-term debt sold by companies. The companies then use that money to cover their current assets, including inventory and accounts receivable. A squeeze on this type of financing can crimp a company's finances, reduce its agility and increase borrowing costs.

''These are major lending institutions in the economy,'' said David Wyss, chief economist at Standard & Poor's. ''When money isn't coming in, they can't make loans.''

There also is some worry about the effect of low rates on mortgage lenders.

When consumers refinance their mortgages, they trade their higher-rate home loans for new loans at lower rates. So mortgage lenders earn less on the new loans.

Lower rates also cut into the returns for holders of mortgage-backed securities, which also have seen their income stream cut by the refinancing boom.

''They are getting all this money back at them before they expected it ... and now have to invest it at lower rates,'' said Patrick Fearon, an economist at A.G. Edwards & Sons Inc. in St. Louis.

Banks see their margins pinched from lower rates because falling yields generally narrow the spread between what banks can offer depositors and how much they earn on their own investments.

And lower rates boost how much companies have to contribute upfront to cover their pension obligations. That's sure to cut into corporate earnings.

It's all a balancing act. Take from one side, add to another, and the Fed's job is to decide which is more important.

Rachel Beck is the national business columnist for The Associated Press. Write to her at rbeck(at)ap.org



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