The pain of zero interest rates

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Article Highlights

  • Withdrawing the Fed's easy money fixes abruptly could kill the economy or make it a lot sicker.

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  • Savers face catch-22 of low returns from safe assets versus negative returns on stocks.

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  • Pain of low interest rates is less than pain that would result from higher rates and damaged recovery.

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The pain of zero interest rates

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The current economic environment of low—virtually zero—interest rates has hit savers hard, but the US Federal Reserve’s accommodative monetary policy is actually having a stabilizing effect on the economy. Abruptly raising interest rates could harm economic growth and the housing market. Until the economy stabilizes enough that the Fed can start to slowly raise interest rates, savers have several less-than-ideal options, including adjusting their lifestyles; dipping into their savings; and taking on riskier investments, such as gold and stocks.

Key points in this Outlook:

  • By holding interest rates at zero, the Fed has forced many households to accept painfully low returns on their savings.
  •  Amid high volatility and with memories of the Lehman crash still fresh, savers are understandably reluctant to invest in stocks or gold.
  • Like it or not, the economy needs the Fed’s easy-money drug. Withdrawing it now could kill the patient.


Fed Chairman Ben Bernanke has been asked so many times about the pain—in the form of lost income—that zero or low interest rates are causing household savers that he now mentions in nearly every speech or testimony how he and his Fed colleagues are aware of such hardships. But then he goes on to signal that the Fed expects to keep interest rates “exceptionally low” for nearly two more years.

How and why did we get to zero interest rates? Savers who planned a few years ago on, for example, 5 percent rates are ending up with zero income on money market funds or Treasury bills. What, if anything, can be done to change this? What options are open to households—or firms, for that matter—that want better returns on their savings? Be forewarned that the choices are difficult ones.

Behind Zero Interest Rates

To understand how we got here and what our options are, it useful to ask a question: what happens when savers get to care more about return of capital than return on capital? In short, what would we expect to observe in financial markets when savers are really spooked or even in a liquidity trap?

First, we would expect to see just what we are talking about: low-risk assets, those on which return of principal is virtually assured, would become very popular. Even though the Fed has pushed interest rates on such assets to nearly zero, the flood of cash into Treasury bills, insured bank accounts, and money market funds has continued. (See figure 1.)

Although frustrated savers could perhaps hope to earn more by taking some risk—buying stocks or gold, for example—many are reluctant to do so. Stocks were flat last year, and while gold rose smartly, it provides no ready income unless it is sold above purchase price. And if it is sold within a year of purchase, gains are taxed as ordinary income, not at the preferential capital gains rate. The same is true of stocks unless they pay a dividend—hence the popularity of dividend-earning stocks. Even then, the underlying value of the stock can be volatile. If dividends or interest payments on bonds just make up for a loss in underlying asset value, the result is a zero return with more risk than on a bank deposit for which the value is fixed (save for loss to inflation, which I will discuss.)

That said, there are always winners. Those who bought long-term Treasury bonds early last year—probably against the advice of most financial professionals—reaped a handsome capital gain—some 30 percent on the best-timed purchase of thirty-year bonds. Yields on thirty-year bonds dropped below 3 percent, while all yields fell sharply to levels below those during the 2008 Lehman crisis. (See figure 1.) This outcome is a sign that risk-averse long-term investors are reaching for yield without risking principal for those holding such assets to maturity. Pension funds and insurance companies come to mind. Of course, some individual stocks did very well over the year, but investors have to ask themselves if they would have been prepared to hold stocks that were dropping fast last August when it looked like a double-dip recession was imminent in the United States, when the European crisis was heating up last fall, or when the debt-ceiling debacle was playing out in July.

A second observable characteristic of spooked savers would be long-term aversion toward riskier assets, like stocks, that on average are expected to pay more than zero returns but whose volatile underlying value makes them riskier than cash. Today, the Standard & Poor’s (S&P) 500 stock index is, after some large fluctuations, at levels last seen in 2006 and 2001. (See figure 2.) Since 2001, just buying and holding the index has, on net, yielded no return, save modest dividends, and quite a lot of risk; suppose, for example, you had needed cash at the end of 2008 during the financial crisis when the S&P 500 had dropped by over 50 percent on the year.

Many households are still asking themselves how they would have managed in such a situation. The question has a sharper point to it for households that have lost all or more than the equity “cushion” they had in their home. Since 2006, the average US home price is down by more than a third: a home that was worth $450,000 now may be worth $300,000 but carry a $400,000 mortgage. (See figure 3.)

On average, the approximately $8 trillion loss on US owner-occupied real estate has severely reduced the risk tolerance of most households while sharply boosting their concern about capital preservation. But when they invest for capital preservation, they risk zero or negative returns alongside possible positive returns. The chance of negative returns is what has them spooked, given their thinner capital cushion.

Consider a generic household close to or in retirement with $250,000 in savings and a retirement income from pension and Social Security of $50,000 per year. (I am being generous here to underscore a point.) When such a household planned for retirement—say, prior to 2007—they could have reasonably expected a 5 percent return, or $12,500 a year, on their $250,000 savings above the equity in their home, which yields no return save the comfort—once upon a time—of access to a home equity line of credit. The loss of their home equity makes them want to hold safe assets that now, given Fed policy and risk aversion, pay a zero return. So the household’s income stays at $50,000, just 80 percent of the $62,500 (including investment returns) they had expected. This is a relatively benign case, so it is little wonder that many households are experiencing “hardship.”"Withdrawing the Fed's easy money fixes abruptly could kill the economy or make it a lot sicker."

Fed's Options

What can the Fed do to alleviate the hardship of zero interest rates? And what can households do to earn more on their savings? The answer to the first question is "not much." The answer to the second is "take more risk." In short, we have a problem.

First, consider the Fed’s options. Suppose it moves to withdraw liquidity by selling assets and raises short term rates to 2 percent—just enough to provide savers with a zero “real” (inflation-adjusted) return. For simplicity, assume that yields on all maturities rise by 2 percentage points. That would take yields on ten-year Treasury notes to about 4 percent, not far from their long-term average. Higher interest rates would eventually result in an increase in annual debt-service costs of about $280 billion on $14 trillion of outstanding federal government debt. Beyond that, stock prices would fall sharply, the housing recovery would stall because of higher interest rates, and a stronger dollar would result in fewer exports.

The reality is that the Fed’s strong stimulants of zero interest rates and extraordinarily easy liquidity conditions are helping the US economy and financial institutions just to hold their own at subpar levels of pricing and growth. Withdrawing these easy money fixes abruptly could kill the economy or make it a lot sicker.

The Fed’s critics argue that these “drugs” never should have been administered in the first place. The Austrian school would say that if the Fed had remained inert after the Lehman crisis, prices would have fallen sharply at first, but expectations of a subsequent rise in prices (higher future expected inflation) would have pushed down real interest rates enough to stimulate investment. The higher investments and subsequent growth would lead to a self-sustaining recovery.

That experiment went badly in the Great Depression and has gone badly in Japan over the past twenty years. Little empirical evidence exists for the Austrian counterfactual assumption that deflation leads to expected inflation. In any case, the economy and investors now heavily depend on low real interest rates, and abruptly withdrawing them could lead to financial collapse and deflation. This might be called cleansing the system, but unless prices somehow started to rise in the midst of an equity, housing, and economic collapse, a very doubtful outcome, we face another Great Depression and some nasty bank failures. For better or worse, the Fed is stuck holding interest rates low and steady for at least another year, and probably longer.

Saver's Options

Savers face difficult options in this environment of low-to-zero interest rates. First, for households whose incomes are constrained, the simplest thing to do in the absence of returns on low-risk assets is to spend less and work more. Indeed, this has been happening and is why the middle class is particularly unhappy."A high level of household risk aversion will probably keep interest rates on safe assets low for some time."

Alternatively, some households fortunate enough to have accumulated assets can dip into their savings to sustain the spending they would have enjoyed if they had normal interest income or investment income from accumulated assets. But this option reduces household wealth and so is not sustainable over long periods of time.

The third alternative is for households to put money in more risky investments, such as stocks or gold. This option is particularly painful for those close to or in retirement, so this group is among those complaining most loudly about zero or low interest rates. Though the price of gold has risen sharply, it is largely a vehicle for professional traders, not risk-averse households. (See figure 4.) Households that take on more risk should realize that they will be joining the ranks of those who support the Fed’s easy money policy of subsidizing risk taking by keeping interest rates low or zero on low-risk assets. Withdrawing that policy would reduce stock prices and probably also gold prices.

The building constituency among risk takers for zero rates raises the risk that the Fed will be too slow to tighten when inflation starts to rise. That concern is valid, but it does not mean that the Fed should start raising rates before inflation starts to rise. Even given the Fed’s highly accommodative stance last year—including the much criticized second round of quantitative easing (QE2), not to mention extra fiscal stimulus—stock prices were flat while long-term bond prices rose sharply. That is evidence of two things: many investors remain risk averse, concerned about return of principal, and few—as yet, at least—are very concerned about rising inflation.

Another simple option for households is to borrow to sustain consumption given low real interest rates. That is difficult to do using a traditional home equity line because many households are underwater on their mortgages and therefore not eligible for such sources of credit. Further, banks are limiting home equity lines, even for homeowners with positive equity.

Given these unattractive alternatives, it is little wonder that many Americans are writing their congressmen about the pain of zero interest rates. That said, Congress can do little other than complain to the Fed about such hardships. The Fed, in turn, can do little given the possible negative market reaction to an abrupt increase in interest rates.
Households will survive by employing a combination of the adjustments suggested above. Spending somewhat less, working longer hours or second jobs, dipping into savings, and taking on more risk are all behaviors evident in the data on the economy. On balance, a high level of household risk aversion will probably keep interest rates on safe assets low for some time.

The Dilemma

As already noted, we are in a classic Keynesian liquidity trap. Interest rates on safe assets are virtually zero, and the Fed’s attempts to stimulate the economy by adding to money and credit have so far not been very successful because risk-averse households are reluctant to spend and invest. The Fed’s extraordinarily accommodative monetary policy and the fiscal stimulus in the form of lower payroll tax rates and extended unemployment benefits are holding the economy at a steady, slow growth rate of about 2 percent. Given the onset of recession in Europe and weaker growth globally, no attractive alternative exists.

That said, the next step for fiscal policy needs to be for Congress to pass credible measures to ensure deficit and debt accumulation reductions in coming years, largely through spending cuts. As the prospect for fiscal sustainability improves, the Fed will hold interest rates steady and low while hoping households will begin to feel less concerned about a debt crisis and rising future taxes so that they start spending at a moderate pace and perhaps purchasing riskier assets. Then, it will be time to start thinking about letting interest rates rise—very slowly.

No quick and easy path back to prosperity after the collapse of an asset bubble exists, especially while Europe is struggling with its own sovereign-debt crisis. That is why bubbles like those caused by policy mistakes in America and Europe need to be avoided in the first place. That said, zero or low interest rates on safe assets are a symptom of most households’ persistent risk aversion that would be unwise to ignore. Most household savers have so far simply not responded to the Fed’s zero-rate invitation to move into riskier assets. But the pain for savers of such low returns is less than the pain that would result from an abrupt withdrawal of monetary stimulus aimed at boosting rates.

Like it or not, the economy and financial markets need the easy money drug for now. It can be withdrawn slowly only once the ailing economy is on the mend—perhaps in 2014.

John H. Makin ([email protected]) is a resident scholar at AEI.

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