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The complex effects of low interest rates on consumption and investment.When interest rates hit double digits in the late 1970s, house-builders sent planks of wood to the Federal Reserve in protest.
With rates stuck near zero, the protests now come from the opposite direction. The retired complain of a “war on savings”.
The Fed cut rates to current levels at the end of 2008 and has promised to keep them there until 2015. Since 2008, personal interest income has plunged 30%, or $432 billion at an annual rate, more than 4% of disposable income.
David Einhorn, a hedge-fund manager, likens zero rates to an overdose of jam doughnuts: too much of a good thing. Raghuram Rajan, a former chief economist for the International Monetary Fund, describes the Fed’s policy as “expropriating responsible savers in favour of irresponsible banks”, and thinks it should raise rates modestly.
This challenges textbook monetary policy. Typically, lower rates stimulate growth in several ways. They reduce the cost of capital, spurring investment and encouraging households to consume today rather than tomorrow. They also boost stock prices, helping spending through the wealth effect, and reduce the exchange rate, helping exports.
Finally, lower rates redistribute income from creditors to debtors, who will presumably spend the windfall. Today’s critics argue that this reasoning no longer applies. Business and households can’t or don’t want to borrow, while the retired and corporate pension sponsors must slash spending to cope with lost interest income.
Are the critics right? Start with redistributive effects. These depend on who are the creditors and who are the debtors. For a net debtor nation like America, lower rates raise national income by reducing the flow of payments to foreign bondholders. (The opposite is true for Japan, a net creditor.)
Lower rates may also benefit households and companies at the expense of banks, which cannot lower deposit rates enough to offset the loss of loan income. In Britain, the Bank of England reckons that between September 2008 and April 2012 lower rates cost households £70 billion of foregone income, but saved them around £100 billion in interest expense. The difference was absorbed by banks.
The actual impact of this redistribution depends crucially on the propensities to consume of debtors and creditors. If the creditors losing income have no choice but to consume less, the hit would indeed be considerable. But reality is more complicated.
In mid-2012 American households held roughly $13 trillion of deposits, bonds and other interest-earning assets, while they owed mortgage and other debts of roughly the same amount. But assets and debts are not evenly distributed. Surveys by the Fed show that while owners of certificates of deposit and bonds were more likely to be older and retired, they are also more likely to be rich (see chart).
Debt, by contrast, is somewhat more egalitarian: 75% of all families carried some, and 47% had a mortgage. For the middle class, interest payments consumed roughly 20% of income compared with 9% for the richest tenth of families.
Although lower rates transfer income from the retired to workers, that effect may be less important than that from rich creditors to middle-class debtors. All else being equal, this probably raises consumption because rich families have a buffer of savings with which to sustain their lifestyle. Middle-income families who lack those buffers must adjust their spending as cashflow changes. The rich are further insulated because lower rates have boosted equities, which are held principally by the wealthy.
So while low interest rates are a burden on many retired people, this has not been enough to suggest the shift of income from creditors to debtors is bad for growth. But what about the effect on investment and spending? For companies, lower interest rates are not all positive. Some must set aside funds that will generate the pension benefits promised to their workers.
As with a bond, the cost of that promise rises as interest rates fall. In Britain, the Pension Corporation estimates that the Bank of England’s quantitative easing (QE), by lowering bond yields, increased pension-plan deficits by £74 billion, even allowing for higher share prices. Since such deficits must be closed over 10 years, sponsors may have to divert cash from investment to their pensions.
In America, corporate defined-benefit pension plans had a deficit of $619 billion, in part because of low yields. They could meet just 72% of future obligations, a near-record low, says Mercer, a consultancy.
QE’s boost to business investment may also be less than generally thought. It reduces bond yields in two ways: it signals that the central bank will hold short-term rates low for longer, and it reduces the supply of bonds. Jeremy Stein, a Fed governor, recently suggested that this second effect, by itself, may not make a company more inclined to undertake capital spending. The company may simply issue a low-cost bond and use the proceeds to pay off short-term debt, or buy treasury bills.
However, Mr Stein said this logic does not apply to households. With fewer financing alternatives than companies, they are more likely to respond to lower mortgage rates by buying houses. But Bill Dudley, president of the Federal Reserve Bank of New York, notes that as consumers age, they spend less on durables such as cars and houses, and thus have less future consumption to pull forward. Americans have not aged enough in the past decade for this to be a big factor, but it may explain why Japanese consumers have not responded more to zero rates.
A final reason why consumers may not respond is that after a debt-fuelled bust, they do not want to borrow or cannot qualify for a loan. But those restraints appear to be lifting. The number of consumers who plan to buy a new home has jumped 50% since July, according to the Conference Board, a business association.
Ironically, American scepticism about the efficacy of low rates may have peaked just as they start to work. There may be reasons to believe that monetary policy is less effective than it used to be, but it is still doing more good than harm.
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