The Federal Reserve knows it has a giant pickle on its hands. Mainly, the U.S. government in all of its infinite and well managed wisdom has borrowed a shit-load of money (and that's a lot - more than a crap load...)
For reference sake, interest rates should exceed the rate of inflation by about 150 to 200 basis points (that's financial lingo for 1.5% to 2.0%). Talking in basis points is secret code for finance dudes.
Now the inflation rate just got bumped up from 3.8% to 3.9%. So using the above interest rate historical info, interest rates should be about 5.4% to 5.9%. It's important that interest rates EXCEED the inflation rate or the lender (the bond holder) is losing purchasing power.
But we see this is not happening in this environment. Long term interest rates (as designated by the 10 year treasury) are about 2.2%. Now any investor should be asking themselves, "If interest rates are 2.2% but inflation is 3.9%, is this a good risk/return investment not even considering taxes and interest rate risk? (Interest rate risk impacts bond holders because if interest rates rise, the value of the bond falls leading to a capital loss for the bondholder.)
But why are interest rates only 2.2%? Great question. The interest rates are being manipulated downward by the Federal Reserve because they are trying to bail out those who are over-leveraged (homeowners) and if interest rates go back to market rates, our U.S. government would get completely squeezed on our budget because we couldn't afford our interest expense. Our government already ran a $1.3 trillion dollar deficit last year (our third trillion dollar deficit in a row). What would our deficit be if our interest expense doubled? How much faster would we spin out of control?
Now, back to the states. We are going to see how unintended consequences play out in the markets. The states have a similar problem in that they borrowed too much money and are running monster deficits. Low interest rates does allow them to borrow funds cheaper. However, one of the biggest problems on the state level is underfunded pensions. Some analysts and organizations put the unfunded pension obligations of the states in the trillions of dollars.
But how are low interest rates screwing the states? We need to understand how pension funds are managed. Pension funds invest contributions in stocks and bonds. As you may be aware, stocks have not been performing too hot lately. And "safe" bonds (i.e. 10 year U.S. Treasuries) are only yielding 2.2%. Pension funds are using a long term compounded rate of return of 8% for most of their models.
But think through the math. Let's just pretend pension funds use a simple asset allocation model of 1/2 in stocks and 1/2 in bonds. If 1/2 the pension funds are invested in bonds yielding 2.2%, what does the rate of return have to be on the equity position to meet the model returns of 8%? The answer would be 14%. But stocks can't grow unless corporate earnings grow. And corporate earnings can't grow unless the economy grows. And currently we are in a no growth or low-growth economy. So equities (stocks) aren't going to grow 14%. They probably aren't even going to grow at 6%. So if 1/2 your pension fund is going to earn 6% (on stocks) and the other 1/2 is going to earn 2.2% from bonds, the total rate of return is going to be closer to 4% which is far from 8% that the models are using.
Now here is the scary part. Even using the 8% future growth projections, the states are WAY underfunded. Lowering that growth rate to more realistic numbers based on market and economic realities means that the states are even MORE underfunded. The only way to make up the difference is to increase contributions towards the pension funds. Contributions + Growth = Future Pension Assets.
But what are we seeing in reality; too little contributions, too little growth = Bankrupt and insolvent pension plans.
And the more the Fed drives down interest rates, the more they are screwing the states and forcing them into bankruptcy because of the underfunded pension obligations.
Low interest rates are actually contributing the escalation in the states fiscal wounds. Another example of "unintended consequences."