In the fast-paced days since Donald J. Trump clinched the U.S. Presidency, financial and media analysts have scrambled to list areas in which the new Trump Administration is likely to upend current policy orthodoxy. President-elect Trump has criticized the Fed’s low interest rate policies as ineffective and distorting, a corner of the U.S. policy arena only now getting serious attention.
Federal Reserve low interest rate policies reduce the incomes of savers and long-term investors. Long-term investors include insurance companies, private- and public-sector defined benefit plans, and government social insurance as well as trust fund programs like Social Security.
Among the winners are large corporate borrowers and governments with ready access to public markets. Low interest rates have done little to reopen bank credit for businesses and homebuyers. Big borrowers enjoy gains; little borrowers not so much.
Moreover, low interest rates help support global stock prices by pushing investors into higher-risk assets. Still, even low interest rate infused stock market gains have their price.
While many assume that low interest rates signal lower long-term returns, the evidence suggests the opposite. Various measures of equity returns have remained relatively stable over time. Rather, the persistence of low interest rates means that equity investors are paying higher prices for the same returns as they did before (i.e., price-earnings (P/E) ratios go up).
Swiss Re, the largest of the global reinsurance companies, has been tracking the economic costs of low interest rates for a number of years. According to their estimates, U.S. households lost almost $1 trillion in potential interest income between 2008 and 2015 and $200 billion in 2015.1
The United States is not alone. In the Eurozone, more than 40 percent of all government bonds now trade with negative interest rates. Globally, almost $7 trillion worth of bonds offer returns below zero. Interest income losses in other countries like the United Kingdom and Switzerland have been as great as or greater than those in the United States relative to the size of their economies.2
Among long-term investors, global insurers have lost $500 billion in returns on their portfolios. The burden of low interest on insurers and on banks is particularly onerous because regulations require that they hold large stocks of government and other “safe” low-return assets in their capital structure. These low-return assets force up insurance company premiums and bank borrowing costs (see our interview with Christian Noyer, Are Negative Interest Rates and Quantitative Easing Compatible?).
Liabilities in defined benefit pension plans in the United States, United Kingdom and Germany suffer as well. Pension liabilities have risen by 30 to 50 percent because of the decline in long-term returns, forcing companies to freeze and/or terminate pension plans and putting public finances under pressure.3
Earlier this year, Moody’s estimated that public sector pension plans in the United States were underfunded in the range of $1 trillion to $3 trillion. The extent of underfunding is embedded into the gap between benefits and contributions but is made worse by low-yielding investment portfolios.4
To be fair, quantitative easing and low interest rates stabilized the U.S. economy after the crisis and helped it heal in the early years of the recovery. However, they have long outlived their usefulness.
As our September Chart of the Month Means vs. Ends: What is the Fed Trying to Accomplish? notes, the Fed’s low interest rate policy has failed to stem the long-term slowdown in U.S. investment, a policy that has driven interest rates lower over time. Are the Fed’s extraordinary policy measures simply sins of omission, or is the Fed willfully ignoring the disruptive effects of its policies because it doesn’t know what else to do?
Presidents have notoriously given the Federal Reserve wide berth. And, in the rare instances where they intervened (President Nixon and Federal Reserve Chairman Arthur Burns, for instance), pressure was applied to lower interest rates — not to raise them.5 Even Trump would likely run afoul of his supporters if he openly challenged Fed Chair Janet Yellen to raise interest rates faster.
Nevertheless, the Fed still holds $4.2 trillion in securities outright — $2.5 trillion in Federal notes and bonds and $1.7 trillion in mortgage-backed securities. The Fed’s stated policy is to allow these securities to “run-off” — hold them to maturity but not replace them. Given that about $1 trillion of the Treasuries mature in more than five years and virtually all of the mortgage-backed securities in more than 10, the current plan will take a very long time.
One would think that the counter policy to quantitative easing would be quantitative tightening, wherein securities that had been purchased in the open market would eventually be sold back into the market when conditions warranted. Selling off the Fed’s balance sheet would add supply to the market in the longer end of the yield curve where demand is high, raising yields and providing investors with scarce high-quality assets. These actions would normalize the yield curve and potentially take some pressure off the Fed to raise short-term interest rates, which can drain liquidity from the economy.
Would Trump consider such a bold action? Probably not. Reports of his economic plans including tax cuts and infrastructure spending suggest that he will likely create as much new Treasury debt as the market can tolerate. Even if the Fed continues to maintain its balance sheet as is, holdings of this magnitude are a major overhang on the public market. Yields are likely to back up further than would otherwise be the case because investors saturated with new debt will worry that there is still more to come.
2 “The costs of financial repression continue to creep up.” SwissRe.com. Swiss Re, 2016. Web.
4 Mooney, Attracta. “The US public pensions crisis ‘is really hard to fix.’” FT.com. The Financial Times Limited, May 1, 2016. Web.
5 Abrams, Burton A. “How Richard Nixon Pressured Arthur Burns: Evidence from the Nixon Tapes.” Journal of Economic Perspectives 20.4 (2006): 177-88. Web.
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