Interest Rates are the Price of money.
When you earn money, you have a choice to make:
- How much will you spend?
- How much will you save?
To help you to decide, you look at the interest rate. In today’s zero interest rate environment, many Americans have chosen to spend their money as quickly as it comes in.
If interest rates are higher than usual (yes it has happened), then people will tend to save more. Here is a look at Personal Savings for the last 45 years:
A large portion of Americans have a negative net worth today. Many Seniors are trying to live off the interest they receive on their life savings. The picture for them isn’t pretty. They’re being killed by the Federal Reserve’s ZIRP, also called Financial Repression.
In order to manipulate interest rates as low as they are, the FED creates new dollars (paper or electronic) out of nothing, and use these new dollars to buy Treasuries. As these dollars trade side by side with previously created dollars, the new ones get their value by stealing a little bit of value from the old ones.
Banks are required to maintain a reserve balance with the FED against their deposits (currently 10%). When the new dollars come in, banks can make more loans than before, up to about 10 times, so each newly created FED dollar can generate 10 new bank dollars, each of which gets its value from the dollars in your pocket. Prices go up because the value of the dollars are going down. In current usage, this is called inflation.
The low rate of interest encourages you to spend rather than save, and then the declining value of your dollars gives you more reason to spend! But spending all you earn, and more, doesn’t allow for the savings which are necessary to replace worn out equipment and expand production with more efficient capital goods.
FED manipulation of the money supply is just plain harmful to the US Economy and to all Americans’ standard of living. The price of money needs to be allowed to find its own natural level. The problem is in getting from here to there. Low interest rates are an addiction for the US Economy. If we try to go cold turkey, we will suffer much pain in a short time.
There are no good choices for how to end the FED’s destructive interest rate manipulation, but I prefer a gradual approach. That way, the markets will know what to expect for a long time, until market rates are reached. When equilibrium will be reached isn’t possible to know, but the 10 year for example likely will go up to above 5%.
Here is what Treasury interest rates look like today:
Source: Yahoo! Finance
Action Item: The FED will be instructed to allow interest rates to rise according to the following schedule (1 basis point = 0.01%):
- Below 0.50% – allowed to rise 1 basis point, 1 day each week
- Below 1.00% – allowed to rise 1 basis point, 2 days each week
- Below 2.00% – allowed to rise 1 basis point, 3 days each week
- 2.00% & up – allowed to rise 1 basis point, 4 days each week
At this rate, it would take 1 year and 4 months for the 10 year to get as high as 5%, at which time the 3 month still will be only 0.82%. The process will take longer than this; my best guess is that we’ll be close after about 2 years. That’s a long time with discomfort, as opposed to severe pain for a shorter time. Again, it’s a big problem with no good choices.