Investors beware! The Fed is on the warpath. Its latest salvo came from Charles Evans, president of the Federal Reserve Bank of Chicago, who is worried about persistently high unemployment. So much so, that he wants the Fed to do much more to spur economic growth. He’d like to see the Fed buy a lot more bonds to drive down long-term interest rates. And he’s willing to pay a steep price for this kind of economic stimulus in the form of higher inflation.
However, interest rates are already low, so it’s difficult to believe that forcing them even lower will stimulate growth. Yet some Fed officials seem convinced that marginally lower interest rates would somehow spur business demand for loans. Their hope is that more businesses will borrow and invest, and eventually hire more workers. They seem to forget, however, that there isn’t much demand for the additional goods and services these businesses might produce.
Mr. Evans has his eye on real interest rates, which economists define as the difference between nominal (i.e., quoted) interest rates and the rate of inflation. If inflation remains steady, real interest rates fall as nominal rates fall. Unfortunately, another way to drive down real rates is to drive up the rate of inflation and hope that nominal rates don’t rise as well. Mr. Evans appears prepared to implement this strategy.
This is certainly bad news for responsible savers, especially retirees and others who live on fixed incomes. Buying corporate bonds is not worth the risk. If the Fed creates more inflation that it bargained for, long-term bond prices could collapse. Already low interest rates mean savers are getting virtually no return on their money. A savings account these days is not much better than putting it into a safe deposit box (or hiding it under the mattress). Add inflation into the mix and you will be severely punished for saving your cash.
Yet this is exactly the Fed’s goal. The Fed hopes that by punishing you, it can get you to change your behavior. Instead of saving money, the Fed wants you to put it to work by spending it. For decades, Americans spent everything they made and then some. Many got themselves into tremendous debt by buying cars and houses they couldn’t afford. Now we’re going through a period of deleveraging, or cutting back on debt. Consumers are acting responsibly just when the economy could benefit from a little more spendthrift behavior. This shouldn’t be a surprise. After all, people are often happy to spend money when they feel confident about the future. When the future is filled with uncertainty, as it is now, they instead shut their wallets and save. This won’t help the economy in the short-term.
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