Who loses when Fed keeps in­ter­est rates low?

“Nor, to my knowl­edge, have key ad­min­is­tra­tion of­fi­cials or mem­bers of Congress. Yet in­ter­est rates close to zero are caus­ing con­sid­er­able dis­tor­tions and, for many, out­right harm.”

The Pak Banker - - Front Page - A. Gary Shilling

I'M amazed that Fed­eral Re­serve Chair­man Ben Ber­nanke has em­pha­sized the ben­e­fi­cia­ries of low in­ter­est rates and has never both­ered to men­tion the losers. Nor, to my knowl­edge, have key ad­min­is­tra­tion of­fi­cials or mem­bers of Congress. Yet in­ter­est rates close to zero are caus­ing con­sid­er­able dis­tor­tions and, for many, out­right harm.

Think about savers who are re­ceiv­ing triv­ial re­turns on their bank and mon­ey­mar­ket ac­counts. Those re­turns would be neg­a­tive if fund man­agers weren't waiv­ing fees. Fur­ther­more, free check­ing ac­counts are dis­ap­pear­ing. Banks and thrifts, fac­ing low in­ter­est earn­ings, have in­creased the size of the re­quired bal­ance on check­ing ac­counts that pay no in­ter­est to $723, on av­er­age, up 23 per­cent in the last year.

The av­er­age fee on non-in­ter­est check­ing ac­counts jumped 25 per­cent to $5.48 per month, also a record. The per­cent­age of non-in­ter­est check­ing ac­counts that are free of charges dropped to 39 per­cent from 76 per­cent in 2009.

Many savers also are de­sert­ing money-mar­ket funds for the safety of ac­counts cov­ered by the Fed­eral De­posit In­sur­ance Corp. This is shown by the col­lapse in M2 ve­loc­ity of money. The ra­tio of M2 to gross do­mes­tic prod­uct in­di­cates that money is just sit­ting in ac­counts, de­spite re­turns that are al­most zero in nom­i­nal terms and dis­tinctly neg­a­tive re­turns in real terms.

In ad­di­tion, the Euro­pean Cen­tral Bank an­nounced in July that it would cut its de­posit rate for banks to zero and its bench­mark lend­ing rate to 0.75 per­cent. With rates this low, man­agers of Euro­pean money-mar­ket funds to­tal­ing $60 bil­lion have closed their funds to new in­vestors. Many were al­ready of­fer­ing re­turns of less than 1 per­cent.

Will Amer­i­cans be dis­cour­aged by low in­ter­est-rate re­turns and save less, or will they save more to reach life­time goals? I be­lieve the lat­ter, which is one more rea­son why I ex­pect the house­hold­sav­ing rate to climb back to more than 10 per­cent. At the same time, low in­ter­est re­turns in con­junc­tion with volatile stock and huge losses on owner-oc­cu­pied houses are forc­ing many vastly un­der­saved baby boomers to work well be­yond their expected re­tire­ments; an­other dis­tor­tion. Sure, bet­ter health care for se­niors and in­creas­ing life spans are also fac­tors, but the per­cent­ages of men and women over 65 and in the la­bor force are ris­ing rapidly. And as se­nior cit­i­zens re­tain their jobs, there are fewer open­ings for younger peo­ple and less ad­vance­ment for those in be­tween.

The Fed in­tends to keep short-term in­ter­est rates close to zero through 2015, and prob­a­bly longer as delever­ag­ing keeps the econ­omy sub­dued and un­em­ploy­ment high. So what can savers do? Hope for de­fla­tion, which will push real in­ter­est rates from neg­a­tive to pos­i­tive?

Banks are also suf­fer­ing be­cause of close-to-zero in­ter­est rates, even though fi­nan­cial in­sti­tu­tions are pay­ing next to noth­ing on de­posits, which continue to swell as savers stam­pede for liq­uid­ity and safety. One se­ri­ous prob­lem is the rel­a­tively flat yield curve. It is an­chored by zero fed­eral funds rates on the short end and pushed down for longer ma­tu­ri­ties, at which banks nor­mally lend, by de­clin­ing Trea­sury yields.

Bank yields on as­sets are in a dis­tinctly down­ward trend, which will no doubt per­sist as the Fed con­tin­ues to keep short rates at zero. U.S. banks also have con­sid­er­able ex­po­sure to the sov­er­eign-debt troubles in Europe. Of their to­tal for­eign ex­po­sure, 24 per­cent is in the euro zone; 44 per­cent if the U.K. is in­cluded. Euro­pean banks are in con­sid­er­able dan­ger be­cause of their large hold­ings of such gov­ern­ment debt.

In­sur­ers, too, have been hurt by low in­ter­est rates, es­pe­cially life-in­sur­ance com­pa­nies whose cash-value pol­icy and an­nu­ities are ba­si­cally sav­ings ac­counts with in­sur­ance wrap­pers.

In­sur­ers largely in­vest in bonds, mort­gages and re­lated se­cu­ri­ties, and de­clin­ing yields on their port­fo­lios are forc­ing them to cut ben­e­fits, de­sign less gen­er­ous poli­cies and raise prices where com­pe­ti­tion al­lows.

These con­di­tions will last for years as ma­tur­ing, higher-yield se­cu­ri­ties are re­placed by lower-earn­ing obli­ga­tions.

Pen­sion funds, es­pe­cially vastly un­der­funded state and lo­cal de­fined-ben­e­fit plans, are prob­a­bly the most se­verely hurt by chronic low in­ter­est rates. Cor­po­ra­tions have been shift­ing to 401(k) and other de­fined-con­tri­bu­tion plans and away from de­fined-ben­e­fit pen­sions, but the lat­ter are un­com­fort­ably un­der­funded, es­pe­cially with low in­ter­est rates and muted in­vest­ment re­turns in prospect. One study found that 42 com­pa­nies in the Stan­dard & Poor's 500 In­dex may have to con­trib­ute at least $250 mil­lion each this year to make up for pen­sion-fund­ing short­falls.

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