At last, the Federal Reserve is sending signals that an interest-rate increase might come next month. That’s good, but a modest bump up, following the one in December, won’t be enough. The sooner the Fed moves from near-zero interest rates-and negative interest rates, the latest central-banker fad-the better.
These policies are toxic for financial stability. They force retired people to curtail spending and discourage the young from saving for retirement. They force people into making risky investments and don’t stimulate economic growth. Worse, they gradually undermine personal responsibility and ensure that future generations are more dependent on government programs.
The Fed has kept interest rates near zero for more than seven years. Experts generally recommend that U.S. households accumulate savings sufficient for 25 years of spending at 80% of earnings the year before retirement. Some savings will be in the form of Social Security benefits. But unconventional monetary policies are making it nearly impossible for most households to achieve the rest.
To understand why, consider an individual with a master’s degree who begins a career at age 25 with a starting salary of $50,000. Assume his expected income increases by $2,500 each year until age 45, when his annual income reaches $100,000 and remains at that level until retirement at age 65. (This mirrors the average for similarly educated people in the U.S.) Let’s also assume that Social Security provides $28,000 a year in retirement, and there is no inflation. How much he will need to save during his earning years to reach his retirement goals depends on interest rates.
If interest rates are zero, accumulated savings earn nothing, and the individual’s total savings must equal $2 million by age 65 to fund retirement. Future Social Security benefits provide $700,000, which means he must save nearly 38% of pretax earnings each year to accumulate the additional $1.3 million. When interest rates are negative, say minus-1%, he must save 49% of every pretax dollar earned. Oh, and the average U.S. college undergraduate starts a career with nearly $40,000 of student-loan debt that must also be repaid out of income over the first 10 years of employment.
Under these conditions, building private savings to fund retirement becomes infeasible for most people and households. Extended periods of ultralow rates also make it more difficult for families to build precautionary reserves-for example, life insurance and long-term care insurance become prohibitively expensive.
The 2013 Federal Reserve Board’s Survey of Consumer Finances, conducted after nearly five years of the Fed’s near-zero rates, found a significant decline in participation in retirement plans. Other studies find a similar trend. A recent report by GOBankingRates estimates that 33% of Americans have no retirement savings, including 24% of those over age 55. Those who do save for retirement face enormous pressure to invest in risky assets to stretch for higher returns. Their demand bids up the price of stocks, high-yield bonds and real estate, creating a price bubble that may deflate once interest rates return to normal levels.
Over time, if a majority of voters lack retirement and precautionary savings or insurance, politicians will be only too happy to introduce new government programs to fill the void. Widespread expectations of government transfers subvert the responsibility to live more prudently and save.
The anemic economic growth of the past seven years has revealed the ineffectiveness of ultralow interest rates. A return to more-normal interest rates is essential if Americans are going to maintain the strong household balance sheets that are vital for weathering financial storms and saving for retirement. Courtesy – The Wall Street Journal