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Money Talks

By Dr. Gregg Dimkoff
Professor, Grand Valley State University
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A variation of Murphy’s Law, which states, “Anything that can go wrong will go wrong,” is the Law of Unintended Consequences. Both are used often as humorous warnings against the belief that we are in complete control of anything.

Both also apply to the Federal Reserve’s efforts to stimulate the U.S. economy. The Fed’s policy of low interest rates is punishing certain segments of the US economy, especially retirees and others with investments in historically safe, interest-paying debt.

The Fed’s usual tools to control the economy have driven short-term interest rates to near zero. For example, three-month T-bills are yielding zero percent while one-year bills yield only 0.09 percent. Have those low rates helped? Yes, they have especially helped banks. Banks are raising money—mostly from deposits—at very low rates and then lending it out at much higher rates. Considering the banking industry’s poor financial shape brought on by loan defaults, helping banks return to profitability is a good thing. It may be one of the Fed’s unstated goals, and it’s working. Low rates also help businesses that routinely borrow short-term money to finance seasonal increases in inventory and accounts receivable.

The Fed usually limits its activities to controlling short-term interest rates when the economy is healthy. But when that’s not enough, it also attempts to influence long-term rates. That explains the Fed’s current attempts to lower longer rates via QE2 and Operation Twist, which changes or twists the maturity of U.S. Treasury debt to a longer average maturity. The Fed does this by selling short-term treasury securities and using the money to buy long-term treasuries. The resulting increased demand for long-term securities drives up their prices, lowering their effective yields — the effective interest rate new buyers will earn. Because all long-term interest rates tend to move together, rates on other types of bonds — and mortgages — will also fall.

The Fed has been successful in doing so. The 30-year mortgage rate has fallen to less than 4 percent, an all-time low, while the 15-year rate is 3.25 percent. The Bloomberg Investment Grade U.S. Corporate Bond Index is yielding 4.86, also a low value compared to historical averages.

Yet whatever success the Fed has achieved in lowering interest rates to stimulate the economy, there remains Murphy’s Law and the Law of Unintended Consequences. Low interest rates are pounding retirees’ retirement funds, government pension funds, employees’ 401(k) plan balances, life insurance company investments and the ability of workers near retirement to stop working.

What do these groups have in common? A significant portion of their money, if not all of it, is invested in various types of historically safe interest-paying debt. But safety isn’t the big issue right now. Instead, it’s yield or, more to the point, the lack of yield.

These groups depend on interest income to meet their objectives. Many have most of their wealth stashed in CDs and bonds. Not surprisingly, their incomes have tanked right along with interest rates, and many are beginning to struggle.

The same thing has happened to bond investments held in pension funds, 401(k) plan balances and life insurance company investments. As interest rates fall, the funds aren’t generating expected returns. And the longer interest rates remain near historical lows, the worse it gets. Employees will have to work longer than they want and will live in retirement with less income. Life insurance companies will continue to lower the interest rates they pay on sales of new fixed annuities, and owners of traditional universal life insurance policies may be asked to raise their premium payments. In addition, cash value projections shown on policy illustrations won’t be achieved. All of these take away expected or current income.

Here’s another example of how the Fed’s efforts to lower interest rates create agony in unintended ways: Lower rates are reducing the rate of return on government worker pension funds. Some Michigan funds assume they will earn a long-term return averaging 8 percent. That’s ludicrous. Annual returns from the stock market have averaged about 1 percent over the past decade, compounding the misery from today’s 2-4 percent returns on long-term T-bonds and 4.9 percent from corporate bonds.

Real trouble for retirees and Michigan taxpayers is building. If rates stay low, retirees will be forced to accept lower pension payments, or Michigan taxpayers will have to pay higher taxes to support retired government workers. Neither alternative will be popular.

Let’s hope the Fed knows what it’s doing, and that, on balance, the benefits of lower interest rates will offset the agony to those who depend on interest rates, especially in retirement. The Fed isn’t always right, and the appropriateness of Operation Twist is highly contentious among economists. Only time will tell.

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