Wednesday, December 4, 2013

Ultra-Low Interest Rates: Who Wins? Who Loses?

Most of the commentary on the ultra-low interest rate policies that have been pursued over the last five years or so by the Federal Reserve and other central banks has focused on whether they were useful in limiting the length and depth of the Great Recession, and whether or how long they should be continued. In their recent discussion paper for the McKinsey Global Institute, Richard Dobbs, Susan Lund, Tim Koller, and Ari Shwayder acknowledge and accept the conventional wisdom that the ultra-low interest rate policies were useful and appropriate as part of the effort to stave off the Great Recession, but that there is some controversy over continuing the policies. But in "QE and ultra-low interest rates: Distributional effects and risks," they then tackle a different if related question: Who has won and who has lost from the ultra-low interest rates? Although their analysis is international, I'll focus mainly on the U.S. results here.

Ultra-low interest rates will have two main sets of distributional effects: the first set involve interest payments made or received; the second set involve how interest rates affect the level of asset prices like homes and bonds. Here's a figure looking at how ultra-low interest rates have affected interest income and payments from 2007-2012.

Of course, lower interest rates help borrowers pay less, while those who are receiving interest payments get less. Thus, the big winner from ultra-low interest rates is the U.S. government, which over the 2007-2012 period could owe $900 billion less in interest payments. Indeed, the McKinsey report also notes that central banks like the Federal Reserve have been buying assets as part of the "quantitative easing" policies in recent years, and funds earned by the Fed over and above operating expenses go to the U.S. Treasury. They estimate that the quantitative easing policies gained the U.S. government another $145 billion or so during this time period. So overall, the ultra-low interest rate policies have been worth about $1 trillion to the U.S. government.

Nonfinancial U.S. corporations have interest-bearing debt in the form of bonds and bank loans, so the low interest rate policies have been worth $310 billion to them. U.S. banks have also seen a rise in their net interest income--that is, the amount by which the interest they received from borrowers exceeded the interest they paid to depositors. (In contrast, banks in Europe as a group have been worse off as a result of the ultra-low interest rate policies.)

On the other side, those who were depending on receiving interest payments are worse off. For example, insurance and pension funds that were relying on interest payments for part of their returns are down $270 billion from 2007-2012. As the report points out, many of these companies hold bonds that they purchased before interest rates fell, and so they have been somewhat protected from the fall in  interest rates. But as the period of ultra-low interest rates continues, insurance companies will either need to shift toward purchasing higher-risk products in search of higher returns, or they may become insolvent.

Household that were relying on interest payments also suffered.  However, because younger households tend to be borrowers, while older households are more likely to be relying on interest income, these losses fall heavily on older households. They also fall heavily on households that have high levels of wealth--in particular, on the 10% or so of US households that have 90% of the financial wealth.

Finally, the rest of the world holds large amounts of U.S. dollar debt: for example, think of China's $3.7 trillion in U.S. dollar reserves. The rest of the world has received about $480 billion less as a result of the ultra-low interest rate policies from the U.S. Federal Reserve during 2007-2012.

Now shift over to thinking about the effect of ultra-low interest rates on asset prices. The McKinsey report estimates that as a result of the ultra-low interest rates, U.S. housing prices are about 15% higher than they would otherwise have been (although this estimate is not intended to be precise!) and value of fixed-income bonds is about 37% higher. (If a bond was issued at some point in the past when interest rates were higher, and now interest rates fall, then the bond is worth more as a result.) The report argues that the effect of lower interest rates on stock prices is minimal. But the first two effects mean that household wealth is up about $5.6 trillion as result of ultra-low interest rates. Of course, these gains are experienced either by those who own a house or by those who own bonds--which again would be the 10% or so of all households that hold 90% of the financial wealth. It's a little tricky to think about these gains in asset values, because presumably at some point when interest rates return to more normal levels, these gains from ultra-low interest rates will fade away.

These distributional effects of ultra-low interest rates may well be less important than the macroeconomic issues of using the low rates to limit the economic carnage of the Great Recession. But the distributional effects are surely large enough to deserve notice. The big gainers are the U.S. government and nonfinancial corporations. The big losers are those trying to save for the future: older households, pension funds, life insurance companies. Other countries around the world have gotten hit in two ways:  not just much lower interest payments than they expected, and also potentially unstable inflows of U.S. investment dollars. When U.S. interest rates are rock-bottom, U.S. dollar investment funds flow into smaller economies around the world seeking higher returns; when it seems as if U.S. interest rates might rise, these U.S. dollar investment flows can easily flee back to the U.S. economy, destabilizing the capital markets and exchange rates of the smaller economies.