Low interest rates are the scourge of the poor and vulnerable

Low interest rates are the scourge of the poor and vulnerable

When central banks allow interest rates to approach, or fall below, what is quaintly termed “the zero lower bound” there are clear losers. Banks are presuming that households, obedient to monetary policy theory, will borrow more money at still lower rates. In fact, the reality is that “lower for longer” prevents a robust recovery because it makes economic inequality worse.

This is especially true in the US. Many American households are already living hand-to-mouth, with more debt than they will ever be able to repay. All lower interest rates do is make it harder for those who might be able to save a little to get a healthy return that might provide financial resilience today and a secure retirement in the longer term.

Low interest rates are tough on vulnerable households; negative rates are brutal. The simple mathematics of what happens to a small savings account shows why post-crisis monetary policy has made inequality so much worse.

Let’s assume you put $2,000 a year, over 20 years, into a savings account paying the historic 5 per cent compound rate of interest. At the end of these two thrifty decades, you will have $69,438 to show for this in nominal terms. In real (inflation-adjusted) terms you have $49,598, assuming 2 per cent annual inflation. So $40,000 earns you an inflation-protected $9,598, or 24 per cent.

Now take the same $2,000 for the same 20 years and the same 2 per cent inflation. But imagine instead that you receive only the 0.5 per cent interest rate that has been paid, at most, on small funds since the financial crisis in the US. Instead of $69,438, you will end up with only $42,168 in nominal terms and $30,120 in real dollars — that is, you will have lost almost 25 per cent. Take the rates negative — say to minus 0.5 per cent — and you, hapless saver, are out by 29 per cent.

In a world of ultra-low rates, most households have no hope of wealth accumulation, no matter how much they save. Indeed, they are better off being profligate.

This damaging result might be acceptable — might be — if lower rates also spurred growth that led to real wage increases. However, American middle-class wages today are no higher than they were in 2001 when inflation is taken into account. Household income may be up in real terms, but that’s largely because many households are now subsisting on multiple wage earners as well as on gig employment. Fully one-third of Americans aren’t working as much as they would like to.

God knows how hard the other two-thirds are working to make ends meet, but we do know that most Americans have far more debt than they have durable assets. A slightly lower interest rate on all that debt might make it somewhat more manageable, but that the debt pile exists at all is a symptom of the deep economic malaise that slightly lower rates only make worse.

The US Federal Reserve’s unconventional post-crisis policy, like that of many other central banks, has been founded on an extremely conventional hypothesis: if low rates spur growth, then ultra-low rates, or even negative ones, will make growth happen even faster and stronger.

But this conventional theory was crafted in the years following the second world war, when the US had a robust middle class with the capacity to borrow when rates dropped and spend their debt on durable consumption with long-term advantages to equality. Put another way, Americans had enough financial security to respond to rate cuts by taking out a bit more debt and spending it on a new car or even a new home, boosting demand, employment and shared prosperity.

Today, with a hollowed out middle class and far more low-skilled workers without enough resources to move to where new jobs might be, the Fed cannot make low rates stoke sustained growth no matter how hard it tries.

The Fed believes it has bought itself some “insurance” with its recent rate cut. Judging by President Donald Trump’s tweets in response, this is not insurance against political risk. It’s also not insurance against market volatility, which increased after the cut, in part because of growing doubts about Fed policy and rising bond-market risks. Neither is it insurance against another financial crisis — the central bank’s proverbial toolbox is now emptier.

Last, of course, Fed governor Jay Powell bought no insurance against still worse inequality and the accompanying macroeconomic, financial and political risk. Instead, by cutting rates, the Fed has just gambled that it can somehow, some time, figure out how best to normalise policy or come up with a better alternative. Time is not on its side.

The writer is managing partner at Federal Financial Analytics

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