February 15, 2012

Defending the Fed

Economist argues central bank must choose between low rates and killing the economy, while savers choose between low returns and risks they can ill afford to take

Criticism of the Federal Reserve has become a mainstay among the financial commentariat, politicians and gold bugs who believe the U.S. central bank is bringing economic ruin–and among regular folk complaining about low rates on savings and checking accounts. Far rarer does one find analysis that comes to defend the status quo, but that is what the American Enterprise Institute’s John Makin has done in a policy paper that argues the Fed’s near-zero rate policy is necessary to prevent a far worse outcome, despite the toll it takes on savers.

Titled “The Pain of Zero Interest Rates,” Makin’s analysis essentially argues that both the Fed and U.S. savers today must choose among unpleasant alternatives.

As regards monetary policy, higher rates would have several negative outcomes. They would add hundreds of billions of dollars annually to U.S. debt-service costs, on top of a $14 trillion debt burden already weighing down the economy; they would put added pressure on the stock market and real estate, still struggling at pre-crisis valuations; and by strengthening the dollar, higher rates would suppress exports. So withdrawal of easy money would “kill the economy or make it a lot sicker,” while the maintenance of an accommodative monetary policy has the effect of stabilizing the U.S. economy, Makin says.

Parallel to the beleaguered central bank is the plight of U.S. savers, especially those at or near retirement, who face low rates on safe assets, though their retirement income projections were likely based on the higher rates of return available in the years before the crisis. Makin says that Fed Chairman Ben Bernanke has made clear he is aware of savers' pain, mentioning it in nearly every speech or testimony. But in order to avoid another Great Depression, his hands are tied.

For that reason, savers must choose among spending less; working more; dipping into their past savings (for those with the luxury of doing so) even if that reduces funds for future spending;  or to do what the Fed policy is meant to encourage: put money into risky assets.

Much of Makin’s analysis is devoted to explaining why that last alternative remains unpalatable to Americans today. Having already suffered portfolio losses and real estate losses, financially scarred savers often feel they can’t afford the risk of loss that ownership of stocks or gold entails. The S&P 500 index is valued roughly at 2001 levels (despite wild swings in between), so investors have seen little return for hair-raising risks.

Makin suggests a thought that must have crossed many investors' minds: “Suppose … you had needed cash at the end of 2008 during the financial crisis when the S&P 500 had dropped by over 50 percent on the year.”

The pain of savers is all the more deeply felt among those who have seen their housing assets sink in value. The average U.S. home is still down by more than a third since 2006, Makin says, intensifying the feeling that they lack the wherewithal to take risk with what’s left, if anything, of their assets.

In the aggregate, Americans’ risk aversion “will probably keep interest rates on safe assets low for some time,” Makin writes, while the weak global economy currently affords no room for a Fed rate hike.

There is no quick path out of this dilemma, but Makin prescribes a reduction in government spending to bring the deficit and debt under control. If consumers see fiscal discipline on the part of the government, they may loosen up their own purse strings, spending more and perhaps shifting into riskier assets. Only then can the Fed consider “letting interest rates rise–very slowly,” Makin argues.

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