The Hidden Cost of Zero Interest Rate Policies

By Laurence B Siegel & Thomas S Coleman – Re-Blogged From

Should the Fed raise interest rates? Some believe that ultra-low interest rates are good for investors because they drive up the prices of stocks and real estate, fattening household balance sheets. Others counter that zero rates are an insidious tax, transferring wealth from borrowers to lenders, distorting incentives and misallocating capital for individuals and government and making the American investor poorer over time.

Where you stand on the Fed raising rates is likely to depend on which of these two positions you support.

We think the latter. Zero interest rates – which translate to negative real interest rates after inflation – are a massive transfer of wealth from investors to governments and other borrowers around the world. We’ll show that the scale of the transfer is nearly $1 trillion per year in the U.S. alone and will argue that the zero-interest-rate policy lowers expected returns on stocks and real estate as well.

Low interest rates hurt more than just investors. Everyone suffers because low rates distort consumption and investment decisions, potentially causing economic growth to be slower than it otherwise would be. Initially, in 2008-2009, low interest rates were an element or consequence of a policy of liquidity injection needed to avoid a collapse of the banking system and serious depression. Since then, however, they have become a tool of stimulative macro policy with limited success.

They are disastrous as an ongoing strategy.

In 1973, the economists Ronald McKinnon and Edward Shaw, looking back on the post-World War II period, described the policies of those times as financial repression.[1] Inflation was high and accelerating, while interest rates lagged behind. Thus, while the real economy grew strongly, savers and bondholders were devastated. The resulting “capital strike” was one of the reasons that we subsequently experienced a decade of high inflation and high unemployment.

Some current commentators, including the celebrated economist Carmen Reinhart, say that financial repression has returned.[2]

But today’s version of financial repression is different from that of the postwar period. The voting public will no longer allow governments to inflate away their debt wholesale with bouts of high and unexpected inflation. But low inflation with even lower nominal rates will accomplish much the same over time by not paying the interest needed to compensate for inflation.

Negative real interest rates are a nefarious tax, punishing savers and depriving the economy of one of its primary sources of income. John Maynard Keynes’s 1919 warning of the effects of inflation apply to today’s era of financial repression: “By a continuing process of inflation, governments can confiscate, secretly and unobserved, an important part of the wealth of their citizens… [W]hile the process impoverishes many, it actually enriches some.”[3]

First, “just the facts, ma’am”

What has been the recent experience of interest rates and inflation? First, we need to distinguish carefully between nominal and real rates. The nominal rate is the stated rate expressed in annual terms; say, an interest rate of 2%. The real rate is the nominal rate minus inflation. For most savings, consumption and investment decisions, it’s the real rate that counts.

Exhibit 1 shows how the Fed responded to the unfolding severe recession of 2007-2009 and its aftermath. Nominal rates plunged from 4-5% in 2006-2007 to essentially zero over the last six years. Meanwhile, inflation has fluctuated around a six-year average of just under 2%. The real rate, then, has averaged just above ‑2% from mid-2009 to mid-2015. During the very recent past, January 2015 to the present, the real rate has been close to zero because inflation, dominated by falling oil prices, has also been zero.

Exhibit 1

Recent experience: Nominal and real short-term U.S. Treasury bill rates and inflation, January 2006-July 2015

Source: Constructed by the authors using data from Morningstar, FRED (the Federal Reserve), and the Bureau of Labor Statistics. Inflation is represented by the CPI-U-NSA.

Financial repression in this century is thus represented by the space between the zero axis and the red real-rate line. That is the “tax” paid by savers due to the zero interest-rate policy. Actually, that is a low estimate of the tax because real interest rates are usually positive, representing a reward to the investor for deferring consumption.

How positive are real rates historically? Exhibit 2 shows the same variables – nominal rates, real rates and inflation, back to 1871 when Robert Shiller’s data series begin.

Exhibit 2

Long-term experience: Nominal and real short-term U.S. Treasury bills and inflation, annually 1872-1926 and monthly 1927-July 2015

Source: Constructed by the authors using data from Morningstar, FRED (the Federal Reserve), the Bureau of Labor Statistics, and Robert J. Shiller. One-year bond yields are substituted for short-term (30-day and 90-day) yields over 1871-1926. Inflation rates are the CPI (CPI-U-NSA where available).

The exhibit looks complex, so a few words of explanation will help:

  • As in Exhibit 1, green is the nominal Treasury bill rate, blue is rolling 12-month inflation and red is the real Treasury bill return.[4]
  • The chart shows annual data from 1871 to 1925, then monthly data from 1927 to the present.
  • Real Treasury bill returns averaged 1.02% over 1950-2006, 0.31% over 1927-2015 (the period covered by the Ibbotson studies) and 1.74% over the whole 1871-2015 period.[5] Nominal rates were much higher, consisting of the real return plus inflation.
  • The ovals show periods of financial repression (red line persistently and significantly below zero) during World War II and the immediate postwar period, the Great Inflation years of the 1970s and early 1980s and recently.
  • Between 1871 and 1926, the large amount of red above the zero axis shows that financial repression was rare during that period, and when it occurred it was due to high and unexpected wartime inflation, not low nominal interest rates. In fact, inflation was negative over most of the period, excepting World War I, which had high inflation, so fixed-income investors did extremely well in real terms.

Financial repression and equities

When we estimate the effect of financial repression on the overall savings of the American public, it’s important to remember that equities and real estate make up large fraction of these savings – probably a majority, if equity in one’s home is counted. While it’s easy to calculate the loss from receiving, say, -2% instead of 0% in real return on one’s cash- and bond-type savings (money market funds and bank deposits), the effect on equities and real estate is more difficult to estimate.

To estimate the effect on equities, consider that the period of ultra-low interest rates has seen a large increase in equity prices and a healthy recovery in home prices. This doesn’t feel like repression; it’s more like a gift from the gods. Where’s the repression?

High prices mean low expected returns. What investors got over 2009-2015 in capital gains on equities they’ll slowly give back (in whole or in part) through lower future returns. This principle applies to houses too. It doesn’t matter if you are buying the equities or houses afresh today or you’ve held them through the last six years – low interest rates do little or nothing to boost the truly long-term returns of these assets, and with high returns already captured in the recent past, future returns have to be lower.

If we assume (for lack of a better estimate) that the loss from financial repression in fixed-income assets is 2% per year relative to what it would be with a more typical and benign policy and that an amount half that large (1% per year) is lost by equity holders due to rich current pricing, we can estimate the size of the implied “tax” on savings. We leave out real estate.


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