The Robbery of the Saving Classes

The Robbery of the Saving Classes
July 14, 2011 by Jeffrey Tucker

AIER offers a devastating analysis of QE1 and QE2 with an eye toward unseen costs: "The Fed's prolonged effort to maintain interest rates at abnormally low level has deprived savers of hundreds of billions of dollars in interest income, ultimately costing the economy between 2.4 million and 4.6 million jobs, $256 and $587 billion in consumption, and 1.75% and 3.32% in GDP growth."

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The Downside of Monetary Easing
Aimed at stimulating the economy, the Federal Reserve's policy has created unintended hardships for savers and a drag on the economy.
Written by William F. Ford, PhD, and Polina Vlasenko, PhD, Research Fellow   
Friday, 01 July 2011 12:58

One of the overlooked consequences of the Federal Reserve's recent rounds of monetary stimulus is the adverse impact those policies have had on the interest income of savers. The prolonged and abnormally low interest-rate structure put in place by the Fed has made life particularly difficult for retirees and others who depend on conservative interest-sensitive investments. But the negative effects do not stop there. They spillover into the overall performance of the economy.

Our estimates show that these negative effects, resulting from the Fed's two rounds of quantitative easing (QE1 and QE2), are sizable and may help account for the lackluster character of the current recovery. The negative effects estimated here should therefore be taken into account when evaluating the net potential benefits of any monetary stimulus.

QE1 and QE2, which together pumped about $2 trillion into the financial system, came about in response to the financial crisis of 2008. To increase liquidity and to keep interest rates from rising, the Fed flooded the financial markets with money by purchasing large quantities of Treasury and mortgage-backed securities.

Monetary stimulus is supposed to bolster the economy through several channels. There is an interest-rate channel. Low rates are expected to spur borrowing and spending. Households tend to borrow to finance big-ticket items like houses, cars, and refrigerators. Businesses finance inventories and investments in plant and equipment. Lower rates may increase the volume of those expenditures by lowering their total cost, driving up economic activity, and lowering unemployment.

There also is an international channel. A widely accepted theory of short-term exchange rate movements is called covered interest parity­roughly meaning that exchange rates move to equalize interest rates across countries. Abnormally low U.S. interest rates, relative to those of our trading partners, drive down the value of the dollar, thereby making American-made products cheaper relative to foreign ones. This leads to a rise in the exports of U.S. goods. At the same time, imports of foreign-made goods, particularly those that compete directly with domestic products, tend to fall or to grow more slowly, also causing U.S. economic activity to rise.



Finally, there is a wealth channel. As the Fed buys long-term bonds, it drives up bond prices and drives down their yields to investors. This induces investors to search for higher returns elsewhere, usually in equities. Increased demand for equities drives stock prices upward, making stockholders feel richer and inducing them to spend some of their increased wealth. This further stimulates output and employment.

But these are not the only channels and effects of low interest rates. There is a downside.

By lowering interest rates to historically unprecedented levels, the Fed's policy deprives savers of interest income they normally would have earned on the interest-sensitive assets they hold. Thus, there is an income channel that no one is talking about, and its negative impact can be powerful.

Interest-sensitive assets exist in many forms. They include savings accounts, certificates of deposit, and money market funds held in banks and other financial institutions. Short- and long-term Treasury and municipal bonds are also in this category, as are huge investments in interest-sensitive variable annuities, held mainly by retirees.

By our most conservative estimate, at the end of the second quarter of 2010, exactly one year ago and one year after the start of the current recovery, the volume of interest-sensitive assets directly held by U.S. households amounted to at least $9.9 trillion.

But the true number may be much higher. Life insurance companies and private pension funds, which provide income to many retirees, also invest some of their portfolios in Treasurys and other bonds. This means that low Treasury yields also affect life insurance and pension fund reserves. Adding those reserves to the pool of assets affected by Treasury yields brings the upper bound of all interest-sensitive assets to $18.8 trillion.

Life insurance companies and pension funds, however, invest not only in bonds but also in equities and other types of assets. From the available flow-of-funds data, there is no way to determine the precise share of bonds within these portfolios. For purposes of this study, we assumed the share of interest-sensitive investments to be 50 percent, creating a mid-point estimate of $14.35 trillion for the total assets affected by the abnormally low interest rates engineered by the Fed.

Table 1 on page 1 shows the difference between Treasury yields on the first anniversary of the nine business-cycle expansions since 1953 and yields in June 2010, the first anniversary of the current recovery's start. That's around the time the Fed first mentioned the possibility of round two of quantitative easing. Recent yields are lower, by a considerable margin, across all maturities of Treasury bills, notes, and bonds than in prior recoveries.

Table 2 below shows our estimates of the possible losses in spending power, output, and employment generated by the Fed's artificially low interest rates. Even by our most conservative estimate, which only looks at the $9.9 trillion in assets most directly affected by depressed yields on Treasurys, the losses are impressive. The average yield on Treasurys in June 2010 was 2.14 percent compared to an average of 7.07 percent in the previous nine recoveries, a difference of 4.93 percentage points. The projected annual impact of this loss of interest income on just $9.9 trillion of rate-sensitive assets translates into $256 billion of lost consumption, a 1.75 percent loss of GDP, and about 2.4 million fewer jobs. (Our calculations assume that the recipients of interest income face a 25 percent average income tax rate and consume 70 percent of their after-tax income.)



Had these jobs not been lost, the unemployment rate would be 7.5 percent, instead of the current 9.1 percent, and this is the minimal effect we estimate.

It is impossible to know for sure what exactly the interest rates would have been in the absence of quantitative easing. We, therefore, present a way to compute the total effect on the economy of interest rate reduction of any size. The first column of Table 2 shows the estimated effect on the economy for every one percentage point reduction in interest rates. If the Fed's policy depressed the yields by two percentage points, for example, the effect would be double of that presented in column 1.

As the estimate of the total of affected interest-sensitive assets gets bigger, the negative effects of depressed yields becomes even more striking. Using our mid-point estimate of $14.35 trillion of interest-sensitive assets, a 4.93 percentage point reduction in interest rates annually cost the economy $371 billion in spending, 3.5 million jobs, and 2.53 percent of GDP. This is a sizable effect, given that during this time GDP grew by only 2.33 percent and the economy added only 870,000 jobs.

With the additional jobs that might have been created by higher interest income levels, the unemployment rate could fall to 6.8 percent. And output could grow more than twice as fast as it has. The resulting GDP growth rate of 4.86 percent would then be closer to the average second-year growth rate of the past nine recoveries, and the U.S. economy would be well on its way to a vigorous recovery, rather than struggling as it is now.

This midpoint appraisal is our best estimate of the likely effect of the Fed's policy. It may still be on the low side.

The numbers do not account for any so-called multiplier effects. Additional spending by recipients of interest income creates revenues for businesses, which in turn increases the income of their owners and employees, who themselves spend more. This, in turn, could boost overall spending and employment by more than the gain in interest income alone would suggest. While some such cascade effect exists in the macroeconomy, determining the size of such a multiplier is more problematic and the source of much debate among economists.

What we know for sure is that the U.S. economy's performance remains anemic. The current rate of job creation is not rapid enough to keep up with the increase in the labor force that arises from simple population growth, nor with the need to absorb millions of currently unemployed workers. The housing market has not even begun to recover since the QE initiatives were created. U.S. auto sales and the stock market also remain well below pre-recession levels. And the sharp decline of the U.S. dollar has not created an export boom. But it has put upward pressure on the cost of our food and energy imports.

And tens of millions of U.S. savers, largely the elderly, still are facing strained circumstances created by Fed-driven abnormally low interest rates across the entire Treasury yield curve.

The negative impacts on output and employment caused by quantitative easing through the interest income effects shown here are large. In fact, they may outweigh the expected, but hard-to-document, positive effects of the QE program.

The implications of this go beyond the current recovery. When evaluating the feasibility of any future monetary easing, the adverse effect on interest incomes always should be taken into account, along with the hoped-for positive effects championed by the proponents of quantitative easing.

http://www.aier.org/research/briefs/2485-the-downside-of-monetary-easing