Low Interest Rates Puts Future Retirees’ Golden Years in Peril

An article in the May 20th issue of the Wall Street Journal described the current trend of investors chasing yield through riskier investments. The reason is the historical low interest rates earned from safer investment vehicles like Treasury securities. With the onset of the 2008 recession, the Federal Reserve reduced short-term interest rates to basically zero. The hope was it would spur personal consumption and business investment and restore the economy to pre-recession employment levels and growth rates. When this did not happen, the Fed resorted to what it called Quantitative Easing, a process in which they purchased billions of dollars in Treasury bonds to reduce long-term interest rates.

These actions by the Fed impacted nominal interest rates, which is equal to the real interest rate plus expected rate of future inflation: n = r + i.

Where:     n = nominal interest rate    r = real interest rate    i = expected rate of future inflation

Though the nominal interest rate is what is published in the newspaper, what matters to investors is the real rate. To calculate the real interest rate, one only needs to use simple algebra to rearrange the above equation: r = n – i. What makes this somewhat unique at times is if inflation is greater than the nominal rate, the real rate is negative.

The two graphs below plot quarterly real interest rates for the Federal Funds rate and 10-year Treasury bonds, along with the inflation rate. I calculated the real rate by subtracting the previous quarter’s inflation rate from the current quarter’s nominal interest rate. The assumption being that there is a one-quarter lag in the release of inflation data. Thus the interest rate on a particular date would change based on the previous quarter’s inflation rate—which is released in the current quarter. For instance, the Fed Funds rate in the fourth quarter of 2013 was 0.09 percent and the inflation rate in the third quarter of 2013 was 1.12 percent. Thus the real rate for the fourth quarter was -1.04 (0.09 – 1.12).

 

Since the beginning of 2002 the real Federal Funds rate registered negative in 32 of 46 quarters—or 70 percent of the time. Since 2007, the real rate for a 10-year Treasury was negative in five quarters.

Such low rates should be of a concern to policy-makers in Washington. Economist John Taylor—the architect of the Taylor-rule—argued that the low interest rates between 2002 and 2005 was the chief cause for the rapid run-up in housing prices; and the subsequent crash in those prices when the Fed raised rates to cool the economy. During this time the real Fed Funds rate was negative for 10 consecutive quarters. The Fed Funds rate is on a current streak of 17 quarters in negative territory.

The Fed argues that the current climate is different than during the earlier period. Quarterly economic growth averaged 3.3 percent and unemployment 5.7 percent during the 10-quarter period of negative real Fed Fund rate. During the current time-frame of negative rates, economic growth has averaged only 1.9 percent per quarter, while unemployment has averaged 8.6 percent.

The low interest rates and anemic economic growth is of great concern for those trying to save for retirement. The reason is it makes it harder to obtain a significant pool of savings needed to maintain a similar standard-of-living when one leaves the workforce. For example, if one invested $100 at 10 percent interest, the investment would double in about seven years. At a five percent rate of return, the number of years required to double the investment is fourteen. At one percent, it takes 70 years to reach $200. Even a one percentage point difference has profound consequences. For instance, a worker, beginning at the age of 25, saves $10,000 for forty years, at a 5 percent rate, would have about $1.27 million in savings at the age of 65. If the interest rate was four percent, the savings after forty years would only be $986,000. At a four percent rate, a worker would need to save $13,000 a year for 40 years to amass the same total as $10,000 per annum at 5 percent.

I understand that the Fed is concerned with short-term economic growth and keeping the economy from falling back into a recession. But eventually the short-term becomes the long-term. Diana Furchtgott-Roth writes of the growing concern such low rates will have on long-term economic growth. At some point the Fed will have claw back the trillions of dollars it has pumped into the economy over the past six years. John Cochrane reports of evidence that expectations for future economic growth have fallen over the past five years. Low interest rates are depriving current workers of sufficient returns on savings needed for retirement. If future retirees’ face lower standards-of-living when they leave work, there will be political pressure to have the federal government make up the short-fall through either higher taxes and/or increased borrowing—both of which would be a drag on the economy.

Over the past six years the government has employed both fiscal and monetary policy in an attempt to restore economic growth—only to fall short. The question becomes what type of economic policy is left? My colleague Ike Brannon suggests tax reform and innovation as two avenues for higher economic growth. This entails implementing policies that will increase economic freedom in the United States. In another post, I write about the fall in economic freedom—as measured by the Heritage Foundation—in the United States over the past decade. It is likely that the increase in onerous regulations has negated much of the positive effects of recent fiscal and monetary policy.

The inability of the U.S. economy to return to its previous long-term average growth rates, despite the massive intervention by the federal government, is an indication that something else is acting as a drag on the economy. Prudent fiscal and monetary policy, along with tax and regulatory reform, must be employed in tandem so as to maximize the economic potential of the United States. For current workers to have the funds available to maintain a standard-of-living that they are accustom to in their golden years it is imperative that the economy returns to historic growth rates and positive interest rates soon.

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