Top-Rated Free Essay
Preview

Interests Rates

Better Essays
1060 Words
Grammar
Grammar
Plagiarism
Plagiarism
Writing
Writing
Score
Score
Interests Rates
Free exchange
Savers’ lament

The complex effects of low interest rates on consumption and investment
Dec 1st 2012 | from The Economist print edition WHEN interest rates hit double digits in the late 1970s, house-builders sent planks of wood to the Federal Reserve in protest. With rates stuck near zero, the protests now come from the opposite direction. The retired complain of a “war on savings”. The Fed cut rates to current levels at the end of 2008 and has promised to keep them there until 2015. Since 2008, personal interest income has plunged 30%, or $432 billion at an annual rate, more than 4% of disposable income. David Einhorn, a hedge-fund manager, likens zero rates to an overdose of jam doughnuts: too much of a good thing. Raghuram Rajan, a former chief economist for the International Monetary Fund, describes the Fed’s policy as “expropriating responsible savers in favour of irresponsible banks”, and thinks it should raise rates modestly. This challenges textbook monetary policy. Typically, lower rates stimulate growth in several ways. They reduce the cost of capital, spurring investment and encouraging households to consume today rather than tomorrow. They also boost stock prices, helping spending through the wealth effect, and reduce the exchange rate, helping exports. Finally, lower rates redistribute income from creditors to debtors, who will presumably spend the windfall. Today’s critics argue that this reasoning no longer applies. Business and households can’t or don’t want to borrow, while the retired and corporate pension sponsors must slash spending to cope with lost interest income. Are the critics right? Start with redistributive effects. These depend on who are the creditors and who are the debtors. For a net debtor nation like America, lower rates raise national income by reducing the flow of payments to foreign bondholders. (The opposite is true for Japan, a net creditor.) Lower rates may also benefit households and companies at the expense of banks, which cannot lower deposit rates enough to offset the loss of loan income. In Britain, the Bank of England reckons that between September 2008 and April 2012 lower rates cost households £70 billion of foregone income, but saved them around £100 billion in interest expense. The difference was absorbed by banks. The actual impact of this redistribution depends crucially on the propensities to consume of debtors and creditors. If the creditors losing income have no choice but to consume less, the hit would indeed be considerable. But reality is more complicated. In mid-2012 American households held roughly $13 trillion of deposits, bonds and other interestearning assets, while they owed mortgage and other debts of roughly the same amount. But assets and debts are not evenly distributed. Surveys by the Fed show that while owners of certificates of deposit and bonds were more likely to be older and retired, they are also more likely to be rich (see chart). Debt, by contrast, is somewhat more egalitarian: 75% of all families carried some, and 47% had a mortgage. For the middle class, interest payments consumed roughly 20% of income compared with 9% for the richest tenth of families.

Although lower rates transfer income from the retired to workers, that effect may be less important than that from rich creditors to middle-class debtors. All else being equal, this probably raises consumption because rich families have a buffer of savings with which to sustain their lifestyle. Middle-income families who lack those buffers must adjust their spending as cashflow changes. The rich are further insulated because lower rates have boosted equities, which are held principally by the wealthy. Capital punishment So while low interest rates are a burden on many retired people, this has not been enough to suggest the shift of income from creditors to debtors is bad for growth. But what about the effect on investment and spending? For companies, lower interest rates are not all positive. Some must set aside funds that will generate the pension benefits promised to their workers. As with a bond, the cost of that promise rises as interest rates fall. In Britain, the Pension Corporation estimates that the Bank of England’s quantitative easing (QE), by lowering bond yields, increased pension-plan deficits by £74 billion, even allowing for higher share prices. Since such deficits must be closed over ten years, sponsors may have to divert cash from investment to their pensions. In America, corporate defined-benefit pension plans had a deficit of $619 billion, in part because of low yields. They could meet just 72% of future obligations, a near-record low, says Mercer, a consultancy. QE’s boost to business investment may also be less than generally thought. It reduces bond yields in two ways: it signals that the central bank will hold short-term rates low for longer, and it reduces the supply of bonds. Jeremy Stein, a Fed governor, recently suggested that this second effect, by itself, may not make a company more inclined to undertake capital spending. The company may simply issue a low-cost bond and use the proceeds to pay off short-term debt, or buy treasury bills. However, Mr Stein said this logic does not apply to households. With fewer financing alternatives than companies, they are more likely to respond to lower mortgage rates by buying houses. But Bill Dudley, president of the Federal Reserve Bank of New York, notes that as consumers age, they spend less on durables such as cars and houses, and thus have less future consumption to pull forward. Americans have not aged enough in the past decade for this to be a big factor, but it may explain why Japanese consumers have not responded more to zero rates.

A final reason why consumers may not respond is that after a debt-fuelled bust, they do not want to borrow or cannot qualify for a loan. But those restraints appear to be lifting. The number of consumers who plan to buy a new home has jumped 50% since July, according to the Conference Board, a business association. Ironically, American scepticism about the efficacy of low rates may have peaked just as they start to work. There may be reasons to believe that monetary policy is less effective than it used to be, but it is still doing more good than harm. www.economist.com/blogs/freeexchange from the print edition | Finance and economics

You May Also Find These Documents Helpful

  • Satisfactory Essays

    •High interest rates:  Investment expenditures decrease .  Government spending stops.  Net exports  Consumption expenditures.…

    • 320 Words
    • 4 Pages
    Satisfactory Essays
  • Good Essays

    Since the financial collapse of 2007 the United States Federal Reserve has maintained a system of policy accommodation consisting of lowering short-term interest rates to near zero levels, and buying large quantities of longer-term Treasury securities in order to encourage new spending and maintain the current prices of assets. Because of this policy, aggregate supply and demand remain relatively unchanged in order to maintain stable prices, moderate long-term interest rates as well as maximum employment.…

    • 1227 Words
    • 4 Pages
    Good Essays
  • Powerful Essays

    Pt1420 Unit 1 Assignment

    • 4255 Words
    • 18 Pages

    When the Federal Reserve sets monetary policy for the US economy, it is also defining monetary conditions for many parts of the emerging world too. These countries mostly don't have the West's debt difficulties. Offer them low interest rates and their economies boom. Demand for commodities surges. Commodity prices soar. For the Western world, food and energy inflation goes up. With weak labour markets, higher prices rise are not matched by higher wages. That means we're all facing real wage cuts. And wage cuts imply lower growth. Lots of people happily talk about a Plan B, as if it's possible to simply wave a magic wand to get us all out of this mess. But until they come up with a solution to the ongoing Japan-style difficulties associated with high debt and low incomes, their magic wands will remain as limp as their ideas. Dreams are all well and good, but every so often it's useful to take a dose of reality. Answer ALL of the following questions. 1 Why is inflation an economic problem? 2 How does an increase in interest rates work to contain/reduce inflation? 3 Why is encouraging growth important? 4 Explain fully the phrase underlined in the passage above. 5 Explain the sentence “Housing markets, meanwhile, are no longer able to deliver the turbo-charged recoveries of old”. 6 Explain the sentence in bold font in the passage above. 10 EXAMPLE OF AN…

    • 4255 Words
    • 18 Pages
    Powerful Essays
  • Good Essays

    You Decide Gm545

    • 589 Words
    • 3 Pages

    * I agree with lower interest rate as Raymond Burke said because lowering interest rates should encourage consumption and investment.…

    • 589 Words
    • 3 Pages
    Good Essays
  • Better Essays

    Feldstein, M. (2008, Summer). Resolving the Global Imbalance: The Dollar and the U.S. Saving Rate. The Journal of Economic Perspectives, 22(3), 113-125. Retrieved from http://search.proquest.com.ezproxy.liberty.edu:2048/pqcentral/docview/212100008/1432735BF913740AA11/22?accountid=12085#…

    • 797 Words
    • 4 Pages
    Better Essays
  • Satisfactory Essays

    GM 545 You Decide

    • 379 Words
    • 2 Pages

    According to Raymond Burke, my economic consultant, his recommendation is to lower interest rates to help businesses and consumers get back on their feet. However, Kathy Lee, a former advisor, believes that raising taxes and reducing government spending can help the current state of the economy. Patricia Lopez, a consultant to the Federal Reserve, believes selling bonds and leaving interest rates as a viable solution. Finally, Allison Tanney, also an economic consultant, believes the Federal Reserve Board needs to increase the money supply by buying bonds, raising interests, and raising reserve requirements.…

    • 379 Words
    • 2 Pages
    Satisfactory Essays
  • Satisfactory Essays

    Giant Pool of Money

    • 299 Words
    • 2 Pages

    The temptation offered by such readily available savings overwhelmed the policy and regulatory control mechanisms in country after country, as lenders and borrowers put these savings to use, generating bubble after bubble across the globe. Usually as one buys the loan, the others follow you.Thus reminding us not to follow bad blindlyand think with your own senses to follow good as far as possible.…

    • 299 Words
    • 2 Pages
    Satisfactory Essays
  • Better Essays

    The economy is one of the most important factors that affects every person and all the organizations in the United States. Since the 1970s, the United States has suffered four recessions and two high inflations. Some people feel that less involvement from the government will decrease bad performance and possibly the economy would be better off. Others individuals feel that the government should be more involved to prevent serious issues such as the current recession. If the Federal Reserve (Fed) was keeping a careful eye on the commercials banks and the major corporations such as American International Group, perhaps some of these current issues could have been avoided. One of the most important things to keep in mind is to forget the “what ifs” and to focus on the process of economic growth. The Fed has three important tools that can potentially influence the economy out of a recession. This paper will talk about these three tools: the power to change the discount rate, reserve ratio, and dealing with open market operations.…

    • 1063 Words
    • 5 Pages
    Better Essays
  • Satisfactory Essays

    I. Overview - The Emergency Economic Stabilization Act of 2008 (commonly called The Bailout Bill and The American Recovery and Reinvestment Plan of 2009 (commonly called The Stimulus Bill) involved massive amounts of taxpayer dollars into the faltering U.S. economy. However the level of bi-partisan support was drastically different. How did the 2008 and 2009 political environments lead to the vastly different levels of support for the “Bailout” and “Stimulus” Bills?…

    • 726 Words
    • 3 Pages
    Satisfactory Essays
  • Good Essays

    Compound Interest and Rate

    • 1839 Words
    • 8 Pages

    1. You are considering various retirement plans. Your goal is to have a lump sum of $3,000,000 available (‘in the bank’) when you retire at age 67. The various plans, with their payment schedules, are listed below. In each case, calculate the payment(s) that must be made into the plan to ensure that you have the $3,000,000 available. For each plan, you may assume that your opportunity cost of funds is 6% per year; for each plan, you may assume that the phrase “at age XX” means the same thing as “on your XX’th birthday”.…

    • 1839 Words
    • 8 Pages
    Good Essays
  • Satisfactory Essays

    Name________________________________ UDC – Quantitative Reasoning I EXAMINATION 3 – Personal Finance – Exponential Functions Fall - 2012 Instructions: This exam is worth 100 points. Read each question carefully. Answer each question clearly and concisely. Please, show All of Your Work. Remember, I do not believe in magic!!!…

    • 588 Words
    • 3 Pages
    Satisfactory Essays
  • Powerful Essays

    Federal Reserve System

    • 1194 Words
    • 5 Pages

    Nonetheless, they have their shortcomings as well. Since borrowing from the Fed is discouraged, they are rarely useful. They are unreliable in that, they are not constant, hence not suitable for decision-making. Also, high discount rates indicate a restrictive policy, which may inhibit user action such as spending. A number of interests charged on borrowed money, in turn, influences other activities such as consumption and business spending. The downside to this is, if the impact is negative, it spreads throughout the…

    • 1194 Words
    • 5 Pages
    Powerful Essays
  • Good Essays

    Many believe that the Federal Reserve System is gaining an excessive amount of power, which can be insidious for the individuals who inhabit in America. The people of America fear the abuse of the power the Federal Reserve System holds. However, if the power of the Federal Reserve System were never expanded, United States would have been in a crisis economically and financially. Due to the Federal Reserve System’s power, the interest rates have been positively impacting the American lives. This is verified by the Time, “The money you have stashed in savings and money markets accounts will earn higher interest.” This demonstrates that the interest rates are not only helping the government, but as well as the people too. Living in the United States requires an essence to obtain savings and due to the work the Federal Reserve System does, the people are receiving interests, or in other terms “free-money”. Therefore, keeping this system would serve as the best alternative for both the government and the people who inhabit in the United States of…

    • 827 Words
    • 4 Pages
    Good Essays
  • Satisfactory Essays

    Econ 545 You Decide

    • 328 Words
    • 2 Pages

    In alliance to such fiscal policy it would also be suggested that recommendations to monetary policy be made. It is important at this time to increase the availability and flow of money. Suggestions that interest rates increase and reserve requirements be heightened would only counter act our recommendations to fiscal policy. If interest rates are increased then the expense to borrow money would not result in positive effect, as would the increase in the reserve requirements, in which banks would have less monies available to lend. So it is my opinions that the president recommend to the FED to lower interest rates to make needed monies more easily available, and to also…

    • 328 Words
    • 2 Pages
    Satisfactory Essays
  • Better Essays

    ECO100 Week 9 Assignment

    • 1129 Words
    • 3 Pages

    Five (5) years back in 2008 interest rates were curbed several times in an endeavor to economic stimulation. The rates of interest commenced on January 2008 at 3.5% and by the climax of the year in December 2008 the rates of interest had been brought down to 1%. At present, the rates of interest are said to be the three-quarters of one percent lessened resting at 0.25% as per the Fed.…

    • 1129 Words
    • 3 Pages
    Better Essays