Costs of the Fed, Part 2

In the previous post I discussed how lowering interest rates adversely affects people with money in savings accounts. I argued that because savers receive less interest income, they have less money to spend, which dampens economic activity. In this post I will return to the idea that lowering interest rates can cause consumers to spend less money. But whereas Part 1 discussed how a decline in interest income affects people who have already saved money, this post will examine how the Fed's actions can change the behavior of people who are trying to build savings.

Economists often teach that lowering interest rates causes consumers to save less and spend more. "Low interest rates provide a powerful incentive to spend rather than save," declares one Federal Reserve publication. The logic underlying this assumption is straightforward: When rates are lower, saving is less attractive and spending is more attractive, so people save less and spend more. If true, this makes Fed policy more effective because when people spend more, the economy grows. And growth is exactly what the Fed is hoping to achieve by lowering rates.

But there is another way to look at this. Consider a family that is trying to save $25,000 for college and $250,000 for retirement over the next 20 years. If interest rates are 5% for the next 2 decades, the family will need to save about $547 per month. With rates at 2%, they will need to set aside $762. The lower the rate, the more they have to save. This runs counter to some of the dominant thinking about lowering interest rates.

Lowering rates probably does cause some people to save less, especially people who are deciding what to do with money that they do not need for basic expenses (ie., rich people). The thinking might go something like: "Should I buy a new Mercedes now or earn 5% for a year and then get the Mercedes with a moon roof? I'll earn the 5%. But if rates are only 2%, it's time to shop." Makes sense. Of course, that is not how a household of limited means and specific financial goals should go about making decisions. For the vast majority of Americans, lowering rates should cause savings rates to increase and spending to decline.

None of this is to say that there are not other factors that might cause people to save less when the Federal Open Market Committee lowers interest rates. When the stock market goes up, people feel richer. I do not dispute that, though I do intend to address some problems with the phenomenon in a later post. Additionally, if the economy does better, confidence rises, prompting people to spend more. However, Federal Reserve publications and Ben Bernanke's many recent statements would have us believe that monetary easing (lowering rates and printing money) categorically stimulates economic growth as long as inflation is not a problem. There has been very little discussion by Fed officials of the ways in which Fed policy causes some pockets of the economy to contract. A cost-benefit analysis that models who wins and who loses - and how much they win or lose - is sorely needed.