The near zero rate acts as a hidden tax paid by the savers to the banking industry. This non-legislated tax on savers has made the savers worse-off
The next Federal Open Market Committee (FOMC) meeting is on March 19. FOMC meetings in the US are the equivalent of the monetary policy meetings of RBI. However, unlike in India, where we are expecting a rate cut in the next policy meeting, there is no such possibility in the US. Interest rates in the US cannot get any lower because they are already at rock-bottom levels.
The Federal Reserve began to cut interest rates in 2007 in response to a financial crisis resulting from a collapse in housing values. The Fed funds rate was lowered from 5.25% in August 2007 to effectively zero by December 2008 and it has remained at that level ever since. And, from what the Fed has said in the past, it is clear that short-term interest rates will remain at this near-zero level through late 2014. If this actually happens, the entire course of the zero rate policy will have lasted six years, an unprecedented and extraordinary policy move on the part of the Fed.
The Fed?s rationale for this policy has gone largely unexamined and unchallenged. Most people submit to the Fed?s expertise and trust the institution to do the right thing to fix the economy, whatever the political cost may be. The general perception is that the world?s largest central bank knows and does the best, and that debate is unnecessary. However, that needn?t necessarily be true. At the very least, we can expect that an unprecedented policy would have unprecedented consequences. A better appreciation of these consequences would give us a better perspective of the Fed?s zero rate policy.
Let?s consider some of the not-so-obvious effects of this zero rate policy. Zero rate policy represents a wealth transfer from savers to banks, as banks end up paying nothing for borrowing money from savers. Thus, it favours the banks at the cost of the average saver. This value transfer for every 1% of interest rate paid less to savers currently is above $40 billion per year and cumulatively exceeds a trillion dollars since 2007 when interest rates were north of 5%. The near zero rate has therefore acted as a hidden tax paid by the savers to the banking industry. This non-legislated tax on savers, that is collected by the banking industry than by the government, has made the savers worse-off.
Yet, savers are left with not too many sensible choices than to park their savings in bank accounts, even at painfully low rates. This is because, even though the zero rate policy is designed to inject inflation into the economy, it actually signals the opposite ? that the Fed fears that the economy may take long to recover. This, in turn, makes the average saver squirrel away money to the bank fearing that the economic recovery could be long-drawn-out.
The only practical choice to stashing money in savings accounts is to invest it in the financial markets. So the Fed?s policy effectively tells the savers?if you want a positive return, invest in financial markets. This unstated gun-to-the-head of savers disregards the relative riskiness of markets vis-?-vis savings accounts. Markets are volatile, subject to crashes, and not right for many investors, especially the older ones. To the extent many are forced to invest in markets, a new financial bubble is being created which will eventually burst leaving many savers not just short on income but possibly destitute. Therefore, an important victim of the Fed?s policies are those average savers who face a Hobson?s choice of gambling in the financial markets or getting nothing at all because of zero rates.
These not-so-obvious consequences are both the intended and unintended results of the Fed?s efforts to revive the economy through a replay of the debt-fuelled borrowing and consumption binges of the past 15 years. Beginning with Fed rate cuts in 1998, which fuelled the tech stock boom-and-bust, through the rate cuts of 2001, which fuelled the housing bubble, until today the Fed has resorted to repetitive bouts of cheap money for extended periods. This monetary ease has found its way into inflated asset values that in turn provided collateral for debt-driven consumption. These binges drove the economy until the inevitable asset bubble collapse caused a contraction in consumption and launched another cycle. At no time were savers rewarded for prudence.
Solutions are straightforward. The Fed should raise interest rates starting with the next FOMC meeting this March 19, by a modest amount of 25 basis points and signal that other rate increases will be coming. The Fed and Treasury can additionally commit to facilitate the conversion of savings into private sector investment by closing or breaking-up too big to fail banks whose balance sheets are littered with distressed assets and are undeserving beneficiaries of the zero rate policy. This will facilitate the creation of clean new banks capable of making commercial and industrial loans to small businesses and entrepreneurs. The result, over time, would be to replace a consumption and debt driven economy with a savings and investment driven economy that rewards prudence and protects the real value of the hard earned assets of the savers. Making money cheap unintentionally taxes the average saver and undeservingly rewards the banks. The ideal policy prescription should have it the other way around.
The author, formerly with JP Morgan Chase, is CEO, Quantum Phinance