Who Loses When Fed Keeps Interest Rates Low?
I’m amazed that Federal Reserve Chairman Ben Bernanke has emphasized the beneficiaries of low interest rates and has never bothered to mention the losers.
Nor, to my knowledge, have key administration officials or members of Congress. Yet interest rates close to zero are causing considerable distortions and, for many, outright harm.
Think about savers who are receiving trivial returns on their bank and money-market accounts. Those returns would be negative if fund managers weren’t waiving fees. Furthermore, free checking accounts are disappearing. Banks and thrifts, facing low interest earnings, have increased the size of the required balance on checking accounts that pay no interest to $723, on average, up 23 percent in the last year.
The average fee on non-interest checking accounts jumped 25 percent to $5.48 per month, also a record. The percentage of non-interest checking accounts that are free of charges dropped to 39 percent from 76 percent in 2009.
Many savers also are deserting money-market funds for the safety of accounts covered by the Federal Deposit Insurance Corp. This is shown by the collapse in M2 velocity of money. The ratio of M2 to gross domestic product indicates that money is just sitting in accounts, despite returns that are almost zero in nominal terms and distinctly negative returns in real terms.
In addition, the European Central Bank announced in July that it would cut its deposit rate for banks to zero and its benchmark lending rate to 0.75 percent. With rates this low, managers of European money-market funds totaling $60 billion have closed their funds to new investors. Many were already offering returns of less than 1 percent.
Will Americans be discouraged by low interest-rate returns and save less, or will they save more to reach lifetime goals? I believe the latter, which is one more reason why I expect the household-saving rate to climb back to more than 10 percent. At the same time, low interest returns in conjunction with volatile stock and huge losses on owner-occupied houses are forcing many vastly undersaved baby boomers to work well beyond their expected retirements; another distortion. Sure, better health care for seniors and increasing life spans are also factors, but the percentages of men and women over 65 and in the labor force are rising rapidly. And as senior citizens retain their jobs, there are fewer openings for younger people and less advancement for those in between.
The Fed intends to keep short-term interest rates close to zero through 2015, and probably longer as deleveraging keeps the economy subdued and unemployment high. So what can savers do? Hope for deflation, which will push real interest rates from negative to positive?
Banks are also suffering because of close-to-zero interest rates, even though financial institutions are paying next to nothing on deposits, which continue to swell as savers stampede for liquidity and safety. One serious problem is the relatively flat yield curve. It is anchored by zero federal funds rates on the short end and pushed down for longer maturities, at which banks normally lend, by declining Treasury yields.
Bank yields on assets are in a distinctly downward trend, which will no doubt persist as the Fed continues to keep short rates at zero. U.S. banks also have considerable exposure to the sovereign-debt troubles in Europe. Of their total foreign exposure, 24 percent is in the euro zone; 44 percent if the U.K. is included. European banks are in considerable danger because of their large holdings of such government debt.
Insurers, too, have been hurt by low interest rates, especially life-insurance companies whose cash-value policy and annuities are basically savings accounts with insurance wrappers. Insurers largely invest in bonds, mortgages and related securities, and declining yields on their portfolios are forcing them to cut benefits, design less generous policies and raise prices where competition allows. These conditions will last for years as maturing, higher-yield securities are replaced by lower-earning obligations.
Pension funds, especially vastly underfunded state and local defined-benefit plans, are probably the most severely hurt by chronic low interest rates. Corporations have been shifting to 401(k) and other defined-contribution plans and away from defined-benefit pensions, but the latter are uncomfortably underfunded, especially with low interest rates and muted investment returns in prospect. One study found that 42 companies in the Standard & Poor’s 500 Index may have to contribute at least $250 million each this year to make up for pension-funding shortfalls.
Corporate defined-benefit plans estimate their future returns on investments, and the median expected rate of return for S&P 500 company plans has dropped to a still very optimistic 7.8 percent from 9.1 percent a decade ago. Furthermore, factoring in current low interest rates on their bond holdings, their expectations for stock returns are often unrealistic. General Mills Inc.’s pension plan needs a 13.6 percent gain on stocks and alternative investments to meet its 9.5 percent overall target, and Hewlett-Packard Co. requires a 15.6 percent gain to reach the 7.6 percent return target for its plan as a whole.
Then there is the discount rate used to determine the present value of future corporate pension benefits. This is based on the yield on corporate bonds over the past two years, which, of course, has been falling. So the rising present value of future liabilities must be offset by even higher investment returns -- which is quite unlikely -- or benefit cuts, which is almost impossible. Otherwise, corporations must contribute more to the plans, cutting into profits. General Electric Co. reported that its compensation expenses in 2011 rose by $7.4 billion because its discount rate fell to 4.2 percent at the end of 2011, compared with 5.3 percent at the end of 2010.
Chronic low interest rates leave defined-benefit pension plans, corporate and public, in the U.S. and elsewhere, with tough choices. They need to reduce asset-return targets and discount rates to more realistic levels, but that means more contributions and/or reduced benefits. Cutting pension benefits is always difficult, especially when employers are restrained by public and private union contracts.
The only other alternative is to increase returns, so pension plans have joined the zeal-for-yield crowd. And this often involves increased risks that may not be fully understood by those plan sponsors. The list of alternative-investment classes includes real estate, private equity, developing-country stocks and bonds, hedge funds and commodities. But returns, especially adjusted for risk, may be disappointing.
In “The Hedge Fund Mirage: The Illusion of Big Money and Why It’s Too Good to Be True,” Simon Lack writes that if all the money that has ever been invested in hedge funds, now about $1.7 trillion, “had been put in Treasury bills instead, the results would have been twice as good.” I can’t argue with him as 30-year Treasuries have been my favorite investment, since October 1981, when rates were 15 percent and I stated, “We’re entering the bond rally of a lifetime.”
Hedge funds initially performed well by taking advantage of arbitrage opportunities and other market disconnects, but most of those holes are now filled, and as Lack observes, hedge funds are finding it hard to find enough good investments to absorb all the investor money that is pouring in.
(In Part 4, I’ll look at how the zeal for yield is pushing investors further and further out on the risk spectrum.)
(A. Gary Shilling is president of A. Gary Shilling & Co. and author of “The Age of Deleveraging: Investment Strategies for a Decade of Slow Growth and Deflation.” The opinions expressed are his own. This is the third in a five-part series. Read Part 1 and Part 2.)
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