A common complaint over the last six years has been that the policies of the Federal Reserve are punishing savers. According to one line of criticism, the Fed has engaged in a recklessly inflationary policy that has eroded the value of people’s hard-earned savings. An overlapping group of critics say that retirees living on fixed incomes have been hit especially hard because the Fed’s “zero-interest-rate policy” denied them a solid return to savings they had accumulated over a lifetime of toil. These low interest rates are sometimes held to have distorted investment patterns, too, driving life-insurance companies and pension funds to take on more risk as the only way to get a decent return.
The inflation argument can be dispensed with easily. That portion of savings not stuffed under mattresses — that is, the vast bulk of it — earns interest. Market interest rates assume an expected rate of inflation. Most savings can therefore be eroded only by unexpectedly high inflation. Yet inflation has been falling, in general, for several decades now, and the last six years have continued that trend.
The argument about interest rates has more merit. But the critics have cause and effect wrong, and therefore reach the wrong conclusions about what the Fed should have done to help savers. It is of course true that, all else equal, savers are better off with higher real interest rates. But the overriding reason that interest rates have been low in recent years is that the economy has been weak. And to the extent the Fed has been responsible for that economic weakness, its role points to a prescription for monetary policy that is very different from what most critics have in mind.
The assumption that the Fed sets interest rates permeates most discussions of monetary policy. But the Fed sets only one interest rate: the federal-funds rate. Through its target for that rate, and its purchases and sales, it influences other interest rates, especially short-term ones. That influence is, however, constrained by general economic conditions.
During an economic boom, firms find it profitable to expand production. They want to invest in tools, machines, and factories, and they finance this investment by either borrowing or using their own savings. In the first case they increase the demand for credit, in the second they reduce the supply of savings, and in both they therefore push interest rates upward. Households act similarly in good times. Expecting higher future incomes, they borrow more and save less, sending interest rates higher.
During an economic bust the opposite happens. Firms expect less profit from production and households expect lower future incomes. As a result, they both borrow less and save more. Their conduct pulls interest rates down.
Interest rates, in other words, tend naturally to follow the health of the economy. A rapidly growing economy experiences rising interest rates, while a slowing one sees falling interest rates. This tendency serves to reinforce the natural healing process of an economy. Rising interest rates provide a natural check on an economy growing too fast, while falling interest rates provide a natural cushion for a weakening economy.
To the extent the Federal Reserve is trying to influence interest rates — and here we will mostly set aside the questions of whether the Fed should conduct monetary policy that way or even exist in its current form — its objective should be to follow this natural interest-rate path. Holding interest rates above the natural rate would be contractionary, holding them below it inflationary, and both should generally be avoided.
During the 1970s, the Federal Reserve attempted to hold interest rates persistently below the natural level and as a result generated double-digit inflation. In the early 1980s, though, the Fed began hewing more closely to the natural rate. It has continued that practice since then, but with notable and regrettable exceptions.
During the early to mid 2000s, the economy experienced economic gains from the opening of Asia and ongoing technological innovations. As a result, productivity soared, firms became more profitable, and households enjoyed higher incomes. Firms and households responded, as expected, by borrowing more and saving less. The Fed, however, was concerned about low inflation and kept its interest-rate target at 1 percent. That decision was a key reason for the emergence of the credit and housing boom during this time.
But if judging Fed policy in relation to the natural rate of interest makes its conduct during those years look blameworthy, it also puts its conduct in subsequent years in perspective. The Great Recession of 2007–09 was the worst downturn since the Great Depression, and its severity implies that interest rates would have fallen significantly on their own. The Federal Reserve’s low-interest-rate policies during the recession and the anemic recovery may to a large extent have followed the natural rate down. It is even possible that the severity of the downturn and the sluggish recovery were due, in important part, to interest rates’ not having been able to fall far enough to reach the natural level.
Economists speak of the “zero lower bound,” or ZLB, on interest rates, referring to the fact that interest rates cannot fall much below zero, because a negative rate means that putting savings in banks or in bonds would actually cost the investor money compared with holding cash. In a severe recession, though, the natural rate might be negative. For example, if the expected return on firm investment fell to minus 3 percent, then interest rates would need to fall at least that low for firms to start investing again. But that cannot happen if firms can hold physical cash at 0 percent. Similarly, if interest rates on checking, saving, and money-market accounts fell to minus 3 percent, then households might decide to start spending again. Here too, households would opt to hold physical cash at 0 percent rather than face negative 3 percent.
Were interest rates able to fall to negative 3 percent in this example, not only would economic activity pick up, but the natural rate of interest would then start rising. Firms and households observing the improved economic outlook would begin to borrow more and save less. Interest rates, in turn, would be pushed back up. Retirees’ interest income would be restored, and investment decision-making would return to normalcy.
The ZLB prevents this market-clearing process from working and helps explain the severity of the Great Recession and the slow recovery from it — as it helps explain the same phenomena in the 1930s. In both cases, the economy hit the ZLB, which made ordinary recessions into severe ones. And the absence of the normal adjustment mechanism meant that it took a long time for the natural rate to rise, which made for a sluggish recovery. Figure 1 shows an estimate, based on the health of the economy and the market’s risk premium, of the natural interest rate during the Great Recession. It indicates that the natural interest rate during the crisis was indeed negative.
The ZLB lies beneath a common explanation of the recent crisis: that people became over-indebted based on unrealistic expectations of future home prices, and then cut spending and borrowing dramatically when prices dropped, causing or deepening the recession. That explanation is incomplete, because under normal circumstances the flow of money from debtors to creditors would have made for increased spending (including investment) by the latter. The decline in debtor spending, therefore, need not have been catastrophic. Banks, for example, might have loaned out new funds and increased the money supply. Instead, creditors, too, increased their demand for safe, liquid assets, including money balances. Total spending fell; the economy contracted. If interest rates had turned sufficiently negative, the demand for liquid assets would have fallen and the supply increased to bring the market back to balance. The ZLB meant that couldn’t happen.
If that were the end of the story, we could conclude that the Fed was blameless for the plight of savers. The “zero-interest-rate policy” is a misnomer, because low interest rates were not the Fed’s policy so much as a condition forced on it and everyone else by the economy. There is, however, an important complication to the story: Fed policy, and expectations about future Fed policy, can exert a powerful influence on the natural rate.
If a central bank creates the impression that it will keep the money supply too low in coming years, for example, it can induce a panic that raises the demand for money balances, lowers expectations of returns on investment, and in both ways reduces the natural rate. These relationships can lead to seemingly paradoxical situations — ones that can flummox the Fed itself.
The Federal Reserve said that the objective of its several rounds of quantitative easing (QE) was to lower interest rates. As Figure 2 shows, however, interest rates on long-term U.S. Treasury bonds actually rose during the periods of QE. What appears to have happened is that the Fed, by signaling that it would maintain a larger money supply in years to come, increased confidence in the economy’s future health and raised the natural rate.
The Fed could have avoided these mistakes, and done better by savers, had it targeted the growth of nominal spending. It would have announced that it intended to keep nominal spending — that is, the total amount of dollars being spent each year on consumption and investment — growing at a rate of 4.5 percent or so, that it would conduct sales and purchases to stick to that target, and that overshooting the goal in one year would be corrected by undershooting it the next (and vice versa).
A Fed so oriented would not have greeted the productivity gains of the early part of the century with lower interest rates. It would have allowed inflation to fall, because it would not have been targeting it. If it had built up credibility about staying on its nominal-spending path and correcting for temporary errors, panic would have been kept at bay in 2007–09 and the recession would have been less severe. The natural rate would not have gone so negative for so long. Savers would have enjoyed higher interest rates because the economy overall would have been stronger.
So savers do have a legitimate grievance with the Fed. But the main line of criticism — that the Fed has hurt savers by keeping the federal-funds rate low — misunderstands that grievance. If the Fed had kept the federal-funds rate higher over the last few years, the effect would almost certainly have been to drive the natural rate lower, leaving savers even worse off.
We appear now to be enjoying, at long last, a real recovery, with interest rates expected to rise. The experience of the last decade or so, though, suggests that the Federal Reserve needs to make a substantial change in the way it does business — for the sake of savers, and everyone else.
– Mr. Ponnuru is a senior editor of National Review. Mr. Beckworth, formerly an economist at the U.S. Department of the Treasury, is an assistant professor of economics at Western Kentucky University.