The US Federal Reserve’s likely decision tomorrow to raise short-term borrowing costs will mark the end of an era of zero interest rates, a period of extraordinary policy experimentation that has yielded mixed results.
Despite the Fed’s aggressive efforts to spur the economy since the 2008 financial crisis, it’s delivered neither the vigorous expansion it wanted nor the disasters its critics feared.
In the process, the central bank emerged less like an all-powerful force and more like so many other institutions that have struggled in recent years to keep up with events beyond their control.
“It was in fact a period of great uncertainty and insecurity for the Fed, “ the central bank’s former chairman, Ben Bernanke, said in an interview.
The Fed pinned short-term interest rates near zero for seven years and added trillions of dollars in mortgage and Treasury bonds through largely untested programs known as quantitative easing to its portfolio to lower long-term rates.
Low rates, by encouraging investment and spending, helped spark an economic expansion now 78 months old, longer than all but four expansions ever recorded. The jobless rate, at 5 per cent, is half its recession peak and half where the rate in Europe remains. A broad measure of unemployment that accounts for discouraged workers and part-timers who want fulltime jobs, has fallen to 9.9 per cent from 17.1 per cent; this measure is as low as it has been since mid-2008, though still elevated historically.
Output and income growth have been disappointing. In one interest-rate-sensitive sector, autos, sales are booming. In another, residential housing, a recovery has been extraordinarily slow.
After-tax incomes adjusted for inflation have expanded at a 1.8 per cent annual rate in this expansion, slower than the average rate of 3.3 per cent during the previous three. Had income grown at the historical rates, Americans would have had $US1.2 trillion more at their disposal.
“The economy didn’t do great,” said Michael Bordo, an economic historian at Rutgers University in New Jersey. “We had a slow recovery.”
New threats now loom. A junk-bond boom is fizzling and could do broader damage to the economy. Other sectors, such as commercial real estate and auto lending, are heating up and could reverse, too. Demand for credit fuelled by low rates is a common ingredient in each case.
“The faster and faster central bankers press the monetary button, the greater and greater the relative risk of owning financial assets,” Bill Gross, bond portfolio manager at Janus Capital Group, said in a December commentary on the looming rate increase.
Still, several warnings by Fed critics have proven wrong. Many expected more inflation. Instead consumer price inflation averaged 1.5 per cent annually since the Fed pushed rates to zero, below the Fed’s 2 per cent goal. In October it was up just 0.2 per cent from a year earlier, according to the central bank’s preferred gauge.
Gold prices, which tend to rise with perceived inflation risks, have fallen 21 per cent.
In a letter to then-chairman Bernanke in November 2010, a group of high-profile hedge fund managers and economists warned the Fed risked devaluing the US currency. The dollar instead has increased 22 per cent in value against a broad basket of other currencies since then, because the US economy is doing better than many others.
Gregory Hess was an economist at Claremont McKenna College in California in 2010 and one of the signers to the letter. In 2013, he became president at Wabash College in Indiana. Low rates didn’t cause the inflation he warned of, but they did help spark a $US25 million dormitory expansion and renovation project at Wabash funded in part by loans fixed at 2 per cent for several years.
“Capital costs have been low and that is attractive,” he said. “Lots of colleges have made expansions to make their campuses more attractive. They have brought forward a lot of projects.”
Still, he said he remained worried about the risks the Fed has taken with the economy and with its own reputation. “Eight years is a long time for the Federal Reserve to be engaging in such continued activist policies,” he said, referring to the rate cuts and emergency measures taken since 2007 as the financial crisis started taking its toll on the economy.
The Fed traditionally moves interest rates up and down to try to rebalance the economy. During a recession it moves rates lower to encourage households and businesses to borrow, spend, invest and hire, spurring economic activity. During expansions it raises rates to restrain spending, investment and inflation. When it pushed rates to zero in 2008, it took additional steps to amplify its actions, buying bonds and promising to keep rates down.
But it’s hard to judge the effectiveness of the Fed’s easy-money efforts in part because the circumstances — the financial crisis, the recession, the crashing housing market — that drove it to act in the first place were so unusual.
One example: The policies aimed to repress saving and encourage spending. Saving has risen during the expansion despite exceptionally low rates. The personal saving rate, which has averaged 5.7 per cent of disposable income since the recession ended, exceeded the 3.9 per cent rate during the previous expansion. This was in part due to households trying to rebuild wealth destroyed by the 2007-09 recession, one of many examples of the powerful forces the Fed was pushing against.
The jump in saving may also have been due in part to the Fed’s own low-rate policies. “Persistent low rates may have dramatically increased the cost of retirement, prompting increased savings,” say economists at UBS Securities. At an inflation-adjusted interest rate of 0.5 per cent, a 50-year-old individual would need to save $US1 million to fund a retirement that produced $US3,000 a month for 30 years. If the rate were a percentage point higher, the same person would need to save $US130,000 less, UBS estimated.
Fed officials have said that raising rates sooner would have increased unemployment and hit the retirement plans of households in other ways by damaging the values of assets like stocks and real estate. Interest income has been constrained, but the net worth of households in the expansion grew from $US56 billion at the end of 2008 to $US85 billion in the third quarter, thanks to rising stock prices and a slow recovery in home values.
Other central banks that pushed rates higher sooner had to reverse course. Sweden’s Riksbank raised its interest rate from near zero in 2010 to 2 per cent in 2011 to slow a housing boom and rising household debt. Then inflation fell and unemployment plateaued between 7 per cent and 8 per cent. The central bank reversed course on rates. Its benchmark is now negative 0.35 per cent, meaning banks have to pay to leave reserves with it.
Mr Bernanke, in his book “Courage to Act,” held out all of Europe as an example of the alternative the Fed didn’t choose. The European Central Bank raised rates twice in 2011, but later lowered one of its key rates below zero. Its unemployment rate remains above 10 per cent.
“The U.S. recovery is among the strongest in the world,” he said in an interview. “The only other advanced economy which seems comparable is the UK, which had very similar policies.”
Even the Fed has had to retrace its efforts. It launched five different variations of bond purchase programs and regularly revised the guidance it gave the public about how long rates would stay low. “They kept changing their story,” said Mr Bordo.
Fed officials say low rates, to some extent, are a force beyond their own control. Economists generally believe there is a “neutral” interest rate, driven by the demand for saving and investment, that keeps the jobless rate and inflation stable.
Fed Chairwoman Janet Yellen argued in a December speech this rate has been driven down by factors outside the Fed’s control, including weak economic growth abroad, slow worker productivity growth, ageing workers, post-crisis uncertainty and tight fiscal policy. Some of these factors may abate, but others might persist, keeping rates low, despite the Fed’s desire to push them higher.
“You can’t go back to where we were before, to the interest rates we were used to, and have satisfactory growth,” said Harvard University economics professor and former US Treasury Secretary Lawrence Summers, who has argued that rates are low because of outside forces causing “secular stagnation” in the economy.
Ultimately, the Fed’s easy-money policies have had risks and rewards.
Because rates on low-risk investments like Treasury bonds are so low, investors have reached to other asset classes for better returns. The Dow Jones Industrial Average is up 65 per cent since the Fed pushed short-term rates to near zero. Commercial real-estate prices are up 93 per cent since then, according to Moody’s.
The commercial real-estate boom is showing up right on top of a Fed branch building in Seattle. Martin Selig Real Estate, a Washington state investment firm, bought an empty six-storey Fed building for $US16 million from the government earlier this year. It proposes to turn it into a high rise, placing 44 levels of office and residential space on top of it, funded in part by a construction loan of $US175 million to $US200 million, with an interest rate set initially near 3 per cent.
“If you have a good project, you can get funded,” Mr Selig said.
A related risk is the debt often associated with asset booms. Debt in the household sector and financial sectors fell from 2008 peaks, but has started rising again. Business borrowing is up 25 per cent since late 2010, according to Fed data.
Many Fed officials believe these were risks worth taking. With high unemployment early in the expansion, “if you’re not courting a little bit of risk, you’re not working hard enough,” Jeremy Stein, a Harvard professor and former Fed governor, said in an interview.
Research by University of Chicago economist Jing Cynthia Wu and Merrill Lynch economist Fan Dora Xia said the Fed’s easy-money policies pushed the unemployment rate down an extra percentage point by late 2013. A study by Fed staff found the extraordinary policies reduced the jobless rate 1.75 percentage points.
As unemployment fell, Mr Stein, who served at the Fed from 2012 to 2014, pressed for an end to the bond buying, worried in part about risks of another bubble. Whether it actually caused one, he said, isn’t yet known.
“The full story won’t be really told until we see how this exit goes,” he said.
(Wall Street Journal)