By Allison Schrager
Last week the Fed announced it would keep buying assets, for now, to keep the economy afloat. But that raises the question: why haven't all the Fed's efforts so far worked better?
One reason is that the economy constantly evolves and each recession is different; that alters the way monetary policy is supposed to work. The latest recession is notable for the way it destroyed households' wealth. Median household net worth fell nearly 40 percent between 2007 and 2010. The severity of the recession also heightened awareness that the world is riskier than many people thought. Each of these factors make people want to save more. The Fed's policy is to keep interest rates low to juice demand. But the state of household balance sheets going into the recession and the aging U.S. population may be why the Fed has not been more successful.
The Fed is currently buying bonds and mortgage-backed securities to keep interest rates low. The low rates are supposed to increase demand through several different channels. One way is through firms; if you lower real interest rates it's cheaper for them to invest, expand and hire. Also, low rates encourage more consumption. They lower the returns to saving so it's cheaper to consume today instead of in the future. This is called substitution effect. Or, the lower rates change how wealthy you feel — this is a wealth effect.
However, whether the substitution or wealth effect dominates, and how strong each is, depends on the age of the consumer. A recent paper from the IMF points out that the aging population may result in less effective monetary policy.
Older people hold the most wealth and savings; they are more sensitive to the wealth effect. Lower rates are supposed to make savers feel wealthier by increasing stock prices and encouraging investment in riskier assets. But that is inconsistent with life-cycle investing: as people near retirement they are usually advised to move out of risky stocks and into safer bonds. Encouraging the near-retired to take on more risk exposure than they'd like may have adverse consequences. They may anticipate having an uncertain future income, and save more to hedge future shocks. Also post-crisis, older people are investing less in equities. Between 2007 and 2010 the share of equities in the portfolio of 65-to 74-year-olds fell from 55 to 44 percent.
For retirees with bonds and savings accounts, low rates make them feel poorer, since they earn less interest on their accounts. Or if retirees are invested in bond funds, the low rates raised the price of bonds. This increases their wealth. But if retirees anticipate an eventual return to high rates (which is likely, because bond yields, unlike stocks, historically revert to a mean), their bond portfolios will fall. So the low rates may have a perverse wealth effect on older people — decreasing their consumption. As the population ages we might expect monetary policy to become increasingly less powerful, or even counterproductive.
By contrast, younger people tend to be debtors, and they are more so now than before. The leverage ratio (ratio of debt to equity) for 35- to 44-year-olds was just 22.3 percent in 1989, but increased to 28.1 percent in 2007, and was 37.3 percent in 2010. Lower rates help them by lowering their debt payments and increasing their cash flows. Debt payments as a percent of income have stayed fairly constant despite more debt; the ratio of debt payments to income only increased from 17.2 percent in 1989 to 20.1 percent in 2010.
Yet this is unlikely to cause a consumption binge. Younger people normally consume more when rates are lower because they are more sensitive to substitution. But that assumes they are saving to begin with, which they barely are. The concept of low rates increasing consumption, through substitution, made sense when people saved more than 10 percent of their income; today American household saving is well under 5 percent. Consuming more will require the young to take on even more debt and it is not clear households have access to more credit.
Households demand a certain amount of liquid and non-liquid wealth, and the low rates are supposed to steer them to more illiquid wealth, like housing. But following a crisis where house prices fell and people found their liquid assets inadequate to hedge economic shocks, it makes sense they'd like to repair their balance sheets and have more liquid assets, no matter what rates are. The economy is riskier than people realized so the premium on safety has gotten large. Since the start of the recession consumers have reduced their debt levels from their peak in 2008, but even in 2013 households still hold as much debt at they did just before the recession. That suggests they have more deleveraging left to do.
While the economy is weak the Fed will keep rates low and buy assets. It is the best immediate policy weapon they have. While monetary policy has not worked as well as hoped, the recession would have been much worse without it. Perhaps more consumption and debt is necessary to get the economy back on track. But eventually the economy will recover. What then? The world has become dependent on a high-consuming American who puts nearly all his wealth in housing. At what point will policy be bold enough to change that? If households don't strengthen their balance sheets, the economy will continue to be fragile and monetary policy will be even less effective in the next recession.
(Allison Schrager is a writer and economist. She worked in finance where she created new, individual pension account investment strategies. She has written for the Economist, Quartz and National Review and has a PhD in economics from Columbia. Any opinions expressed here are the author’s own.)