Points of View
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WHITHER THE WEALTH EFFECT?
Five years into an economic expansion, the Federal Reserve continues to maintain interest rates at historically low levels. The ten-year Treasury Note, our current bellwether, has remained stuck at a yield of 2.6% for almost a year and prior to that was marooned at a yield of 1.6%. The jump from 1.6% to 2.6% occurred suddenly and dramatically last summer after Bernanke hinted that the Fed might be ready to begin tapering its bond buying program. The move down to 1.6% was itself a product of drastic Fed action in the summer of 2012, when Bernanke announced QE3. At the time, the Fed feared that the economy might be in danger of sliding into recession. With fiscal policy stalemated, Bernanke and his colleagues decided that the Fed alone must act. And so the Fed has continued to engineer an unusually low interest rate environment. Janet Yellen, in her initial comments, has been careful to reassure the markets that low rates — accommodative policy as she calls it — will be with us for quite a while yet even as the Fed continues to taper its bond buying. Bernanke and Yellen claim that the low rate policy has been effective over the last several years and continues to give the economy what it needs. Although our current expansion is weak, without the low rates, they claim, the economy would be in much worse shape.
The primary mechanism by which low rates aid the economy, according to Bernanke and others, is through the wealth effect. Low interest rates bolster asset values — primarily stock, bond and housing prices — and thereby make people feel wealthier. Economic research claims to show that for every dollar our assets climb in value we will spend about five cents. This extra spending is what is stimulating the economy and maintaining our expansion, feeble though it may be. Intuitively, the wealth effect seems to make sense. When we feel flush, aren’t we a little more likely to go out to dinner, buy the new dining room set or splurge on a vacation or new car? It might be an open question as to whether a general rise in housing prices provokes us to open our wallets, but surely watching our stock portfolios rise must buoy our spirits. Economists seem to put less emphasis on the positive effects of low rates on corporate earnings and reduced mortgage payments — probably because one person’s reduced expense is another person’s reduced income. The main argument in favor of low interest rates seems to be the psychological one.
In at least one sense, the low rate policy has achieved its desired effect. Stock and bond prices have risen dramatically and provided excellent returns for investors over the last few years. The current bull market in equities has taken the S&P 500 up over 130% since it hit bottom in 2009 and returns on fixed income securities have also been robust. Housing prices are up 30% to 50% in the worst hit markets and up 16% nationwide, according to the Case/Schiller Index. But has spending followed? In the aggregate, not so much. Just look at GDP, plugging along at a 2% to 2.5% real rate of growth, after declining dramatically in late 2008 and early 2009. So, what’s the problem?
Some have questioned the validity of the wealth effect. Research conducted by Hoisington Investment Management shows that the impact of a one dollar increase in wealth is more like one cent of spending, not five cents. Perhaps the problem is that while some people feel wealthier and spend more, others feel, and indeed are, poorer and spend less. This countervailing force, let’s call it the poverty effect, is likely draining away those other four cents. And who are these people suffering the poverty effect? We know them well and there are a lot of them. They are the middle class savers who invest in CDs and interest-bearing accounts. They are retired people, rolling over their fixed-income securities. They are pensioners, buying annuities. And they are an army of baby boomers all about to retire and suddenly finding that their savings won’t support their life styles at 2.6% interest. All of these people have to cut back on spending, either to meet their budgets or to increase their retirement nest eggs. Hence the poverty effect.
Just as the wealth effect is intuitive, so is the poverty effect. One wonders what weight the poverty effect is given in the Fed’s highly elaborate and sophisticated models of the economy. One would guess, not much. Certainly the poverty effect is not discussed; in fact it’s never mentioned. Never by the Fed and almost never by economic professionals. But if Hoisington Investment Management is right, the much-vaunted wealth effect is almost entirely neutralized by the countervailing poverty effect. What economists, mostly of a conservative stripe, do like to point out are the many ill effects of low interest rates: the risk of inflation, bubbles and a general misallocation of capital. Some have also pointed out that banks are loathe to lend to small and medium sized businesses under a low-interest rate regime. Returns on such loans are meager and don’t compensate for the risks involved.
So, why does the Fed do it — why keep rates so low for so long? Why is the Fed blind to the poverty effect and dismissive of the risks generated by low rates? The answer, one suspects, is a fear of roiling the markets. With growth sluggish and unemployment still high (likely near 10% if all those who want to work but have given up are counted), the Fed is fearful of taking any action that will spook the stock and bond markets and trigger fears of another downturn. Like a junky who can’t get off the juice, our economy is now addicted to cheap money and shuffles from quarter to quarter with slow growth and weak employment.
If the Fed had the courage to move us back to a normal interest rate environment, what would that look like and how would the economy likely react? Without the Fed’s actions, the rate on 10-year Treasuries would likely track the growth in nominal GDP — somewhere in the range of 4% to 4.5%. If 10-Year Treasury rates were thus to rise 150 to 200 basis points, 10-Year Notes would lose 14% to 18% of their value. One suspects that the stock market would decline by a similar amount. The S&P 500 is currently trading at 1878; the index would likely fall to approximately 1550 to 1600, or back to where it traded in the spring of 2013. Mortgage rates would rise, but the housing market has cooled anyway. Could we live with such financial pain? I suspect we could, without succumbing to another financial panic. And what would we get in return? All of those people who are now suffering the poverty effect would get their own wealth effect boost: middle class CD buyers, senior citizens and that horde of baby boomers facing imminent retirement. Banks might even give small and medium sized businesses another look. And yes, housing prices would fall – and maybe the Millennials would start buying. The 1% have had a good run. Maybe it’s time to let the rest of the country have a taste. There is no doubt that a new dynamic would be created in the economy — and that’s just what we need.