The Hidden Cost of Zero Interest Rate Policies

Should the Fed raise interest rates? Some believe that ultra-low interest rates are good for investors because they drive up the prices of stocks and real estate, fattening household balance sheets. Others counter that zero rates are an insidious tax, transferring wealth from borrowers to lenders, distorting incentives and misallocating capital for individuals and government and making the American investor poorer over time.

Where you stand on the Fed raising rates is likely to depend on which of these two positions you support.

We think the latter. Zero interest rates – which translate to negative real interest rates after inflation – are a massive transfer of wealth from investors to governments and other borrowers around the world. We’ll show that the scale of the transfer is nearly $1 trillion per year in the U.S. alone and will argue that the zero-interest-rate policy lowers expected returns on stocks and real estate as well.

Low interest rates hurt more than just investors. Everyone suffers because low rates distort consumption and investment decisions, potentially causing economic growth to be slower than it otherwise would be. Initially, in 2008-2009, low interest rates were an element or consequence of a policy of liquidity injection needed to avoid a collapse of the banking system and serious depression. Since then, however, they have become a tool of stimulative macro policy with limited success.

They are disastrous as an ongoing strategy.

In 1973, the economists Ronald McKinnon and Edward Shaw, looking back on the post-World War II period, described the policies of those times as financial repression.[1] Inflation was high and accelerating, while interest rates lagged behind. Thus, while the real economy grew strongly, savers and bondholders were devastated. The resulting “capital strike” was one of the reasons that we subsequently experienced a decade of high inflation and high unemployment.

Some current commentators, including the celebrated economist Carmen Reinhart, say that financial repression has returned.[2]

But today’s version of financial repression is different from that of the postwar period. The voting public will no longer allow governments to inflate away their debt wholesale with bouts of high and unexpected inflation. But low inflation with even lower nominal rates will accomplish much the same over time by not paying the interest needed to compensate for inflation.

Negative real interest rates are a nefarious tax, punishing savers and depriving the economy of one of its primary sources of income. John Maynard Keynes’s 1919 warning of the effects of inflation apply to today’s era of financial repression: “By a continuing process of inflation, governments can confiscate, secretly and unobserved, an important part of the wealth of their citizens… [W]hile the process impoverishes many, it actually enriches some.”[3]

First, “just the facts, ma’am”

What has been the recent experience of interest rates and inflation? First, we need to distinguish carefully between nominal and real rates. The nominal rate is the stated rate expressed in annual terms; say, an interest rate of 2%. The real rate is the nominal rate minus inflation. For most savings, consumption and investment decisions, it’s the real rate that counts.

Exhibit 1 shows how the Fed responded to the unfolding severe recession of 2007-2009 and its aftermath. Nominal rates plunged from 4-5% in 2006-2007 to essentially zero over the last six years. Meanwhile, inflation has fluctuated around a six-year average of just under 2%. The real rate, then, has averaged just above ‑2% from mid-2009 to mid-2015. During the very recent past, January 2015 to the present, the real rate has been close to zero because inflation, dominated by falling oil prices, has also been zero.

Exhibit 1

Recent experience: Nominal and real short-term U.S. Treasury bill rates and inflation, January 2006-July 2015

Source: Constructed by the authors using data from Morningstar, FRED (the Federal Reserve), and the Bureau of Labor Statistics. Inflation is represented by the CPI-U-NSA.

Financial repression in this century is thus represented by the space between the zero axis and the red real-rate line. That is the “tax” paid by savers due to the zero interest-rate policy. Actually, that is a low estimate of the tax because real interest rates are usually positive, representing a reward to the investor for deferring consumption.

[1] McKinnon, Ronald I. 1973. Money and Capital in Economic Development, Washington, DC: Brookings Institution. Shaw, Edward. 1973. Financial Deepening in Economic Development, New York: Oxford University Press.

[2] Reinhart, Carmen M., Jacob F. Kirkegaard, and M. Belen Sbrancia. 2011. “Financial Repression Redux,” Finance & Development, Vol. 48, No. 1 (June).

[3] Keynes, John Maynard, The Economic Consequences of the Peace, Harcourt, Brace and Howe, 1920, p. 205. We are also reminded of Lenin’s comment that the surest way to ruin a nation is to debauch the currency.