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Vectra Bank Expert Jeff Thredgold

Low Interest Rates...a Two-Sided Coin

Written by Jeff Thredgold, President, Thredgold Economic Associates

August 30, 2011

Last week’s Tea Leaf discussed the fact that long-term interest rates were the lowest in nearly 50 years, providing great opportunities to refinance a home or to purchase a new or foreclosed property at near record-low mortgage rates. 

The Tea Leaf issue also discussed the reality that anxious stock market investors around the U.S. and around the globe have been pulling billions of dollars from stock markets and reinvesting into U.S. Treasury securities (bills, notes, and bonds), still viewed as the most risk-free and marketable securities in the world…regardless of what Standard & Poor’s thinks.

We have noted previously that the Federal Reserve (this nation’s central bank) has set its most important interest rate…the federal funds rate…at a record low target level of 0.00%-0.25% since December 2008, a period now reaching 32 months.  Equally important, the Fed’s monetary policy arm—the Federal Open Market Committee (FOMC)—noted a few weeks ago that it would maintain this rate at the current record low “at least through mid-2013”…unlike any statement the Fed has ever made.  A Federal Reserve that has traditionally found value in keeping financial market players guessing as to impending monetary policy changes, for the moment, abandoned such policy in a major way.

Good Intentions
The intent of incredibly low longer-term interest rates is clearly to provide greater incentive for consumers and businesses to borrow for various reasons, and for homeowners to take advantage of very attractive refinance or home purchase opportunities.  Unfortunately, the combination of weak U.S. economic growth, high unemployment, anxiety about Europe, enormous and destructive budget deficits, and a general mistrust in the political direction of this nation have largely kept consumer and business borrowers on the sidelines. 

One might logically assume that incredibly low mortgage interest rates of recent weeks and attractive home prices would lead mortgage applications to jump sharply.  One would be incorrect.  In fact, as reported last week, applications for new mortgages hit a 15-year low!   Refinance applications dropped as well. 

Why aren’t more homeowners and would-be homeowners taking advantage of such low interest rates?  The Mortgage Bankers Association in a statement blamed the fall on “volatile markets and rampant uncertainty,” which kept home purchasers on the sidelines.  Today’s reported plunge in consumer confidence only supports that view!

Fewer mortgage lenders and more complex and onerous lending documents compliments of Uncle Sam have only added to the weakness.  Businesses have kept new borrowing under wraps and limited hiring for the same general reasons, including major anxiety about the damage being done by politicians in Washington DC.

Flip Side of the Coin
Even as the low interest rate game has largely failed to ignite the housing and business sectors, another major victim of the extremely low interest rate policy exists.  It is the millions of older and retired people who have seen their interest income drop like a rock.

The old adage of investing in stocks during one’s primary working years and then shifting from stocks to “fixed-income” investments for greater “safety” has been a disaster in recent years.  It will get worse over the next 2-3 years.

Tens of millions of retirees would argue they did everything right.  They shifted from volatile stocks to bonds and certificates of deposit (CDs) and money market funds and saving accounts, seeking to sleep better at night with the 3% or 4% or 5% or 6% or 7% annual returns provided by these fixed-income investments over the past 20 years.

Then the bottom fell out…

The Fed cut its key interest rate to near zero, with all other short- and intermediate-term interest rates plunging as well.  Money market funds now pay an average of 0.01% annually.  Savings accounts average 0.15%.  One-year CDs pay 1.00% or less. 

Two-year U.S. Treasury notes now provide a less-than-exciting annual return of 0.19%.  Even a five-year U.S. Treasury note yields less than 1.00% annually. 

Overall interest income in the economy fell by 27% between 2008 and 2010 (The Associated Press).  Additional painful declines will occur as bonds and CDs that were purchased three or four or five years ago at more attractive rates are rolled over at rates approaching zero. 

Individually…Collectively
I see this with my own mother who now rolls over maturing CDs or IRAs at incredibly low interest rates.  She noted that she recently had an IRA mature and was offered 0.10% annually on the renewal.  A few complaints finally pushed the rate all the way up to 0.40%.

We all know retired people with similar stories.  However, the cumulative “macro” or collective impact on the U.S. and global economies is highly significant.  Tens of millions of retirees have seen their monthly and annual incomes cut dramatically. 

Retirees now travel less; support the arts, local restaurants & museums less; and donate less.  In addition, the value of their homes has declined sharply in recent years, also leading to less confidence about tomorrow’s financial future.

It would be better if incredibly low interest rates were matched by incredibly low inflation.  Such is not the case.  As discussed in last week’s issue, consumer inflation during the most recent 12-month period was 3.6%.  Many economists would argue that inflation is actually higher for retired people as they spend more on health care, food and basic necessities…and less on technology, where prices have been consistently declining.

If It Sounds Too Good to Be True…
One unfortunate bi-product of retirees facing severe financial pressures is their susceptibility to financial schemes.  Yes, this is also true for all age groups. 

It seems that one can find in a newspaper almost weekly someone who was arrested for running a Ponzi scheme or a “get rich quick” program geared to older consumers.  There is an investment adage that is always true...the higher the return, the higher the risk…and vice versa.

If someone promises you a 5% or 7% or 10% monthly return in an investment opportunity…run the other way!  They can tell you it is safe and it is guaranteed.  They can and will tell you whatever is necessary to satisfy your fears and get their hands on your money. 

If it sounds too good to be true…it is!

There is a case to be made that a higher level of short-term interest rates (perhaps 2% or 3%), driven by the Fed, would benefit the economy.  Borrowers would still have access to extremely low long-term financing costs.  In addition, retirees and savers of all ages would see interest incomes rise, allowing for greater spending across the economy...

…maybe the Fed will figure this out at some point.


Finance Expert Right Boarder