David Shulman is a retired Wall Street executive who is now a senior economist at the UCLA Anderson Forecast. He is also affiliated with Baruch College (CUNY) and the University of Wisconsin.
Last week the Federal Reserve Board announced, once again, that it was committed to maintaining its zero interest rate policy through 2014. Nearly four years have passed since the Fed adopted the policy. What began as an emergency measure to support the entire financial system in late 2008 has seemingly become permanent policy at the Fed. The current rationale for the policy is that extraordinarily low interest rates are required for the Fed to fulfill its full employment mandate. With the unemployment rate above 8 percent as it has been for the past four years, the economy is far away from full employment which implies an unemployment rate in the 5-6 percent range. Simply put, we are short about 5 million jobs.
The Fed's policymakers rightly assume that an environment of low interest rates stimulates business investment and enables consumers to more easily finance big ticket purchases such as housing and automobiles. Over time it also lessens the burden of existing debts to free up cash to make additional purchases. Moreover lower short-term rates have the effect of forcing investors to reach for income by lengthening the maturities of their portfolios and by taking on more risk. To make sure that investors actually behave in this manner the Fed has adopted a policy of quantitative easing where it goes in the market place to buy long dated securities and mortgage backed bonds to directly lower their interest rates. This process raises both stock and bond prices. As a result through lower financing costs and higher asset prices more goods and services are demanded and unemployment declines.
All of the above is consistent with what passes for macroeconomic theory today. However, the theory behind the zero interest rate policy leaves out quite a bit of downside scenarios that act contradictory to policy. There are two very real negative aspects to the current policy. First the very low interest rate environment forces current retirees who rely on interest income to support themselves to reduce their spending. More importantly the low rate environment plays havoc with retirement planning for both individuals and pension plans.
For example, individuals planning for retirement have to assume lower rates of return on their investments, and, therefore, if they want to achieve a target amount of assets in the future they have to save more today. Saving more today means buying less stuff today and that works against the demand effects implied by low interest rates. One way to save more is for older workers to stay in the labor force longer. In fact the only growing segment by age in employment during the past few years has been in the over 55 years of age category. By working longer, older workers are blocking the way for young workers who are now locked out of the labor market. This state of affairs is hardly what the Fed contemplated when it embarked on its zero interest rate policy.
For defined-benefit pension plans, the low interest rate environment wreaks havoc with the actuarial assumptions that are at the very foundation of their ability to pay benefits. The low rate environment means that that future investment returns will be lower and the discounted value of future benefits will be higher. In other words the safety and solvency of defined benefit plains have been undermined.
In response, the plan sponsor, either the corporation or the governmental entity, has to put more cash into the pension plan each year because the plan assets will be earning insufficient returns to fund the previously promised benefits. That means instead of investing in new plant a corporation has to utilize its excess cash or actually borrow to fund its pension plan. In the case of government it means layoffs of public employees or higher taxes to pay for current and future retirement benefits. This too lowers current spending and works to offset some of the demand increases that would normally come from lower interest rates. The problem here is zero interest rate policy could very well work in the short run, when individuals and plan sponsors perceive the very low rate environment to be temporary, but once that perception is changes, all kinds of offsetting activity begins to take place.
Perhaps more pernicious is the effect the policy is having on federal finance. With short-term borrowing costs at zero and the overall net borrowing cost of the federal government now running at a very low 2.1 percent average interest rate, both the Congress and the president appear to avoid the consequences of running up trillion dollar budget deficits year after year. Thus the Fed has become the enabler of a very reckless fiscal policy of spending too much and taxing too little.
To be sure Fed Chairman Ben Bernanke lectures Congress every six months on the need to reduce the deficit, but as long as he is keeping short-term interest at zero there are no negative consequences associated with borrowing binge the federal government is now on. Let's perform a simple thought experiment. In fiscal year 2011, the federal government reported net interest expense of about $220 billion, roughly the same as in fiscal year 2008. Thus after three years of mega deficits, borrowing costs held steady as the interest rate on rolling over debts plummeted. Now for our experiment let's assume that in 10 years the interest rate normalizes at a modest 4.2 percent and the debt itself increases by, say 50 percent. What happens to net interest payments? They triple to $660 billion a year! And on the White House's own numbers this eventuality is expected to occur in fiscal 2018.
To put $660 billion into perspective, that is about one quarter of the total receipts that the federal government is projected to take in in fiscal year 2012. Trust me, the Fed understands this arithmetic, but they are acting in the way a sub-prime lender did five years ago by sucking us in with a very low teaser rate that will ultimately explode in our faces.
The markets understand this arithmetic as well. As long as Congress and the White House delay in putting our fiscal house in order, a cloud of uncertainty will hang over investment decisions as businesses and individuals ponder what the tax and spending environment will be over the next few years. This results in reduced current investment and represents a drag on the economy. Thus it might help if the Fed ceased enabling the politicians to continue on their reckless ways. So instead of contemplating a new round of quantitative easing, the Fed instead, should be thinking about returning to a more normalized interest rate policy.