David Peartree, The Daily Record Newswire
Quantitative easing and low interest rates may have prevented the catastrophic failure of the global financial system — that, at least, is a widely accepted view — but their direct impact on many individuals and households has been less benign. QE and low interest rates are costing many individuals significant dollars.
A recent report quantifies the “distributional effects” of QE and low interest rates. “Distributional effects” is a policy wonk’s way of describing how money has flowed from one pocket to another.
The Fed’s monetary policies have created winners and losers. A recent report by McKinsey Global Institute, “QE and ultra-low interest rates: Distributional effects and risks,” reports on the impact of these policies over the past five years.
In response to the financial crisis starting in 2007 and the resulting global recession, the Federal Reserve took two basic steps. First, they forced short-term interest rates to near zero by lowering the federal funds rate. Then, to reduce long-term interest rates they embarked on QE, the process of buying large quantities of longer-term Treasury and other government or agency securities. In the most recent round of QE, the Fed has been buying at the rate of $85 billion per month.
The winners
The U.S. government has been the major beneficiary of these policies and this appears to be by design. The effective rate on outstanding U.S. government debt was cut in half, falling from 4.8 percent in 2007 to 2.4 percent in 2012. Lower interest on its debt is estimated to have saved the U.S. government $900 billion in payments between 2007 and 2012. The Fed also has earned additional interest on all the assets it has added to its balance sheet from buying government bonds.
The combined impact of lower debt service payments and interest earned on its balance sheet is an estimated $1 trillion benefit for the U.S. government. Large U.S. corporations, including banks, also benefitted by an estimated $460 billion in lower interest payments on their debt. The U.S. government and large corporations have benefited because, in the aggregate, they hold more interest bearing liabilities than interest earning assets.
The losers
U.S. households have been net losers under the Fed’s monetary policy because, in the aggregate, they own more interest earning assets than interest bearing debt. U.S. households are estimated to have lost $360 billion in interest income over the five-year period. Repressed interest rates on cash deposits and money market funds have punished savers for five years running. A year’s worth of interest on $1,000 will now barely buy a cup of coffee.
It is true that younger households, generally age 45 and younger, are net borrowers and borrowers have benefited from historically low rates. Across all households, however, but especially older households that are net savers, low interest rates have been a detriment.
Insurance companies also have been hurt by low interest rates and that should concern policyholders. Insurance companies are not natural objects of sympathy but policyholders ought to sit up and pay attention because whatever pain the insurance companies experience will be passed on to policyholders.
Insurance companies are major investors in fixed income assets and low rates put them in a real bind. On the one hand, because the majority of their portfolios are invested in fixed income assets, rising interest rates will cause them pain, at least temporarily, by depressing the market value of their portfolios.
On the other hand, the current low rates make it difficult to meet the minimum guaranteed returns on fixed rate policies. The McKinsey report estimates that 45 percent of premium dollars are directed to policies with a fixed rate.
If a company has guaranteed a 4 percent return on policy values but is unable to earn that in the marketplace, they have another way to make up the shortfall. They simply increase policy charges and take it out of policy values. They may credit a policy with a 4 percent return, for example, but then increase the policy charges as they are permitted to do under virtually all cash value type insurance policies.
It’s not just fixed rate policyholders who should be concerned. If the business model for insurance companies suffers, and suffer it must under ultra-low rates, then all cash value policyholders can be affected.
Low interest rates means low fixed income returns and policyholders who are not paying attention may suddenly find their policies in distress. A policy may either run out of cash or get hit with a significant and unexpected premium increase to keep it in force.
There are several lessons here for investors and policyholders.
First, understand how the current policy of interest rate repression works. Its primary objective appears to be to allow the government to finance greater spending at a lower cost. Yes, the higher purpose is to promote economic growth, but along the way many households are experiencing collateral damage.
Second, the Fed’s policies force many investors into an uncomfortable trade-off: either keep safe funds in cash and accept no returns or chase higher yields in riskier asset classes. This, too, is by design. The Fed has been fairly open about its desire to see investors bid up the price of riskier asset classes so they feel wealthier, spend more, and thereby promote economic growth. Investors need to decide whether it’s prudent for them to take the bait.
Third, insurance policyholders need to monitor policy performance at least annually. That should include testing a policy’s long-term viability by requesting in-force illustrations under several sets of assumptions involving different levels of returns, expenses and premium payments.
A primary “distributional effect” of the Fed’s monetary policy has been to shift dollars toward itself and away from others. Individual investors and policyholders are left to look after their own financial interests.
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David Peartree, JD, CFP is the principal of Worth Considering, Inc., a registered investment advisor offering fee-only investment and financial advice to individuals and families. Offices are located at 160 Linden Oaks, Rochester, NY 14625; email david@worthconsidering.com.
