The Federal Reserve of New York lowers rates from 5.5% to 5% on September 21. The rest of the Fed branches match in tandem. The powerful New York Federal Reserve President (Governor pre-1935), Benjamin Strong, delivers a terse statement to the Journal. Equities seem nonplussed and drop the next day. The aggregate yield on high quality debt rallies from 4.8% to 4.5%.
Downward pressure on the natural rate of interest (r∗) is often attributed to an increase in saving. This study uses microeconomic data from the SCF+ to explore the relative importance of demographic shifts versus rising income inequality on the evolution of saving behavior in the United States from 1950 to 2019. The evidence suggests that rising income inequality is the more important factor explaining the decline in r∗. Saving rates are significantly higher for high income households within a given birth cohort relative to middle and low income households in the same birth cohort, and there has been a large rise in income shares for high income households since the 1980s. The result has been a large rise in saving by high income earners since the 1980s, which is the exact same time period during which r∗ has fallen. Differences in saving rates across the working age distribution are smaller, and there has not been a consistent monotonic shift in income toward any given age group. Both findings challenge the view that demographic shifts due to the aging of the baby boom generation explain the decline in r∗. .
The received wisdom among economists is that the US’s historical low interests rates are driven by high savings by aging boomers who are getting ready for, or in, retirement.
The idea is boomers have salted away so much cash that banks don’t bid for their savings, so interest rates fall.
But at last week’s Jackson Hole conference, a trio of economists presented a very different explanation for low interest, one that better fits the facts.
So we can’t really say that low interest rates are being caused by an aging population with high retirement savings, because while the US population is aging, it does not have high savings. Quite the contrary.
And, as Robert Armstrong points out in his analysis of the paper for the Financial Times, even in places like Japan, with large cohorts of retirees and near-retirees who do have adequate savings, rates are scraping bottom.
So why are rates so low? Well, the paper says it is being caused by high levels of savings — just not aging boomers’ savings. Rather, it’s the savings of the ultra-wealthy, the 1%, who are sitting on mountains of unproductive capital, chasing returns.
The core of the problem is that as inflation soared, bond yields fell, creating an instant contradiction: Inflation is poison to bond investors, so they would normally be expected to sell. I have an explanation, but it isn’t perfect.
My take: Investors came to the realization that the huge post-pandemic debt burden will keep rates lower than in the past, while they kept faith that inflation will be manageable. There is little to indicate investors fear a recession-inducing mistake by the Federal Reserve, and they aren’t expecting runaway inflation either.
The market response from March to the start of this month can be thought of as pricing in a repeat of the secular stagnation brought on by the 2008 financial crisis, with the twist of slightly higher inflation than in the past decade.
And there is one more oddity that is far harder to understand: By Aug. 3, yields on 10-year Treasury inflation-protected securities, or TIPS, reached minus 1.2%, the lowest point for inflation-adjusted yields in history.
It could only make sense if investors were expecting stagflation, or weak economic growth combined with higher inflation. But if the risk of stagflation were rising, investors should be buying gold — which usually rises when TIPS yields fall — and dumping the junkiest corporate bonds, as defaults would be sure to rise. Instead, the relationship between gold and TIPS broke down, while junk bond yields rose only a little from what had been close to record low spreads over Treasurys.
Former U.S. Treasury Secretary Lawrence Summers said the Federal Reserve’s massive bond-buying program is resulting in a “bizarre” situation in which the government’s funding structure is overly focused on the short-term.
Under its quantitative easing program, the Fed purchases longer-term Treasuries and the money it creates to buy them ends up in the accounts that banks hold with the central bank, in the form of overnight reserves.
These reserves earn a rate of interest that’s linked to changeable overnight benchmarks — currently 0.15% per year. That, in effect is the rate the government, through the Fed, is paying to borrow this money.
At the same time, any payments the government makes on Treasury bonds to the Fed is ultimately a flow from one part of the government to another and, arguably, cancels itself out in the end. So the upshot is the government owes, in real terms, less longer-term fixed-rate debt and more shorter-term floating-rate debt.
Historically, bond yields have not been very good at predicting inflation.
In the last 70 years, bond yields rarely rose ahead of inflation, going up only after inflation takes hold. One study indicated that past inflation trends were a better predictor of bond rates than what future inflation turned out to be.
Does this mean bond traders are wrong? Not necessarily. It may just reflect that inflation is unpredictable and bond traders don’t know any more about the future than the rest of us. All they have is the past data and current prices to make their predictions, too. So when inflation suddenly spikes — as it has in the past — bond traders are as surprised as everyone else.
The Fed has embarked on a massive expansionary quest in recent years. In 2020, total Reserve Bank assets rose from $4.2 trillion to $7.4 trillion amidst the pandemic and related government lockdown and fiscal “stimulus” policies. That was roughly three times the extraordinary growth in the consolidated balance sheet for the Reserve Banks in the 2008-2009 financial crisis. And in the latest weekly “H.4.1” release, total assets were up to $7.8 trillion – rising about a hundred billions dollars a month so far this year.
Today, short and long-term interest rates on government bonds rest near historic lows, important in part because the Fed massively expanded its purchases of government bonds. But low interest rates can’t be taken for granted, particularly if we get significantly higher inflationary expectations — which appear to have begun to sprout in recent weeks.
If we get significantly higher interest rates for that reason, the Reserve Bank balance sheet impact from losses on securities assets would arrive if the losses become “realized” – a realistic prospect if the Federal Reserve reverses course and starts selling off securities as a means of conducting monetary policy amidst higher inflationary expectations.
The concern with this exercise is its reliance on past returns. With interest rates near zero, significant economic growth is needed to generate market returns close to those experienced over the last 100 years – approximately 11% per annum. To explore the implications of different future investment performance, let’s repeat the process above by reducing the average return of historical stock returns while maintaining the same risk (i.e., volatility).
Panel A shows that as the return on Lena’s savings increases, i.e., we move from left to right along the horizontal axis, the value of investing the money relative to paying off the mortgage early increases. At a 3% savings return, the cost of her mortgage, Lena would be indifferent between saving extra money and paying down her mortgage early because both options lead to similar average savings balances after 30 years. Savings rates higher (lower) than 3% lead to higher (lower) savings for Lena if she invests her money as opposed to paying down her mortgage early. For example, a 5.5% average return on savings, half that of the historical return, leads to an extra $57,000 in after-tax savings if Lena invests the $210 per month as opposed to using it to pay down her mortgage more quickly.
Panel B illustrates the relative risk of the investment strategy. When the return on savings is 3%, the same as the cost of the mortgage, the choice between investing the money and paying down the mortgage comes down to a coin flip; there is a 50-50 chance that either option will lead to a better outcome. However, if future average market returns are 5.5%, for example, the probability that investing extra money leads to less savings than paying down the mortgage early is only 26%. For average returns above 6.5%, the probability that investing the extra money is a bad choice is zero. In other words, there hasn’t been a 30-year historical period in which the average stock market return was below 3%, even when the average return for the 100-year period was only 6.5%.
The first observation in the United States motivating the GSG hypothesis is the protracted decline in long-term real interest rates, as shown in figure 1. This figure depicts both a Treasury Inflation-Protected Securities (TIPS) rate and an expected long-term real interest rate, computed by subtracting from the nominal yield on ten-year Treasury securities the measure of ten-year expected inflation from the Survey of Professional Forecasters (SPF).8 From 2003 on, the TIPS rate is for the ten-year TIPS. Before 2003, we use a 30-year TIPS rate, data for which are available starting in 1998, subtracting 40 basis points from it to reflect the average term premium observed in the years when both the ten-year and 30-year TIPS are available. At the time Bernanke first articulated the GSG hypothesis, much of the focus was on Greenspan’s conundrum—that is, the continuing drop in long-term rates in 2004–05 despite repeated hikes in short-term rates during a strong economy. However, with the benefit of hindsight, the much longer-run, apparently secular nature of the drop in long-term real interest rates is evident. Very roughly, it seems fair to say that the ten-year real interest rate in the United States declined about 150 basis points between the latter half of the 1990s (when it averaged around 3.5 percent) and the prelude to the global financial crisis (when it averaged around 2 percent), and then it fell another 200 basis points commencing with the collapse of Lehman Brothers in September 2008 and continuing to the present. While the first drop of 150 basis points is very plausibly a consequence of capital inflows, the post-crisis drop of 200 basis points is unlikely to be attributable primarily to the GSG;9 instead, that second drop suggests a somewhat parallel story of weak domestic investment in the United States.
Further, under EPPRA, the interest rate used to calculate withdrawal liability for plans receiving assistance is limited. The interest rate used to calculate withdrawal liability would be capped, in part, by subsections of ERISA, plus 2%, which would currently be approximately 5%. Of course, the lower the interest rate used by a plan for this purpose, the higher the resulting employer withdrawal liability.
Importantly, less than 15% of the 1,400 multiemployer pension plans will receive financial assistance. Accordingly, the bulk of employer obligations to multiemployer plans, even those that are significantly underfunded, will be unaffected by EPPRA. With respect to employers who contribute to plans that receive EPPRA assistance, PBGC is expected to issue guidance that would limit (in whole or in part) the benefit of such assistance to employers.
The impact of EPPRA’s special financial assistance on contributing employers will largely depend on PBGC regulations and guidance. Employers who are currently confronted with an immediate decision regarding withdrawal from a multiemployer pension plan (for example, employers in the middle of labor negotiations) likely will need to exercise patience pending the issuance of PBGC guidance.
Author(s): Paul A. Friedman, Robert R. Perry, David M. Pixley
The 25 largest U.S. banks currently hold 45.7% of their assets in loans and leases, according to Fed data released Friday, down from 54.1% this time last year. Meantime, their year-over-year holdings of Treasury and agency securities increased 33.5%. This reflects more-stringent borrowing standards and diminished loan demand. But it also reveals a subtle yet persistent change in how banks operate.
Banks have pulled back from making risky loans in favor of engaging more directly with the Fed — avoiding the type of lending that spawned stricter regulatory standards after 2008 while readily accommodating the Fed’s expressed satisfaction with an “ample reserves” regime. Bank lending to small businesses has remained low throughout the postcrisis years, with the largest declines in small-business lending at large banks, as shown in a 2018 report commissioned by the Small Business Administration.
The switch is understandable. The cost of regulatory compliance is a huge disincentive for banks, and selling government-backed securities to the Fed and piling up reserves can turn out to be a profitable business model.
Coronavirus vaccines will hopefully get economies humming this year, as people feel comfortable returning to shops, businesses reopen and workers get jobs again. The International Monetary Fund expects the global economy to grow 5.5% this year following last year’s 3.5% plunge.
A stronger economy often coincides with higher inflation, though it’s been generally trending downward for decades. Congress is also close to pumping another $1.9 trillion into the U.S. economy, which could further boost growth and inflation.