Lower interest rates are a double-edged sword that hurts some even as it helps others, and there is no getting around that. An interest rate is a price, little different than the price for onions, gasoline or freelance newspaper columns for that matter. Just as for these items, not everyone agrees on whether a low price for money is good or bad.
In any transaction, the two parties have opposing interests. Consumers want onions to be as inexpensive as possible. Onion growers prefer higher prices. Self-employed pundits want to earn more, but newspapers must keep costs down.
Interest is the price paid for the use of money over time. Borrowers want to pay as little as possible and welcome lower interest rates. Savers want to get as much as possible. What benefits one group harms the other.
But interest rates differ from other goods in an important way. Governments cannot create onions or essays at will. Farmers need soil, seed, and machinery to grow onions. Pundits need hours of time, myriad references and a bit of education.
A central bank, however, can create new money or destroy it effortlessly. Just change the policy directive to the New York Fed’s open-market desk and it will swell or shrink the money supply.
From March 2006, to March 2008, the broad measure of the money supply grew by $885 billion. That is about 6.4 percent per year. Some $394 billion of that occurred since last July, just before the Fed started to pump out money in earnest.
The Federal Reserve is charged with managing the money supply to achieve stable prices and low unemployment. In practical terms, that means manipulating short-term interest rates. The Fed cut its target for interest on overnight loans by 3.25 percentage points in the last seven months.
That has pushed down other short-term rates. The six-month Treasury bill now earns about 1.6 percent, down from 4.1 percent before the first Fed rate cut.
That’s only 2.5 percent, you may say. Yes, but if you have retirement savings in T-bills, you just suffered a 60 percent drop in interest income. Some who have rolled over T-bills recently are getting less than a third of the income from the new bills than from those that just matured. Interest income from six-month certificates of deposit has dropped 40 percent.
Rising inflation adds to savers’ pain. Short-term interest rates, adjusted for inflation, are now negative. In summer 2000, T-bills paid nearly 6 percent when inflation was 3 percent, so the real, inflation-adjusted rate was 3 percent. In July 2006, when the Fed last raised rates, T-bills were just under 5 percent and the CPI was rising about 4 percent for a real rate of 1 percent. The real rate right now is a negative 3 percent.
Borrowers benefit, but savers suffer. That is the inevitable result of a central bank pushing down interest rates. Time will tell what the overall result is for the country as a whole.
© 2008 Edward Lotterman
Chanarambie Consulting, Inc.