What's Wrong with Low Interest Rates
Murdoch, Guy, Consumers' Research Magazine
Interest rates on cash investments (savings accounts, CDs, money markets) have dropped precipitously in recent years. This is in keeping with the government's stated policy of keeping interest rates low to encourage loan activity and economic growth. The resulting focus on borrowers and their well-being, however, obscures the impact of such interest rates on savers - many of whom look to interest payments as an important source of income.
In an April speech, President Clinton said that his budget proposal "has led to a 20-year low in mortgage rates, dramatically lower interest rates ... And so we are moving in the right direction." Such sentiment about the virtue of low rates has been echoed throughout government for many years. And indeed those with debts who can take advantage of the lower rates, such as mortgage holders, governments, and corporations, have certainly benefited.
For savers, though, it is an entirely different story. When rates drop - whether by government fiat or market forces - their earnings on interest-bearing investments also drop. The average annual return (yield) on a taxable money market fund dropped 41% in 1992, from an average of 5.7% in 1991 to 3.37% in 1992, according to IBC/Donoghue, a market research organization and publisher of investment newsletters; interest rates on 3-month CDs dropped 37%, figured on the same basis. In other words, in one year, falling rates reduced income from these investments by a third and more.
This flip-side to declining rates has received scant, if any, attention from the government, but it has a direct impact on those, such as retirees, who rely on interest to supplement their income. "The net effect of lower interest rates is a redistribution of income, with borrowers benefiting at the expense of savers," says Lacy Hunt, Ph.D., chief economist U.S.A. for HSB Holdings, plc., who adds that "consumers are net creditors for the rest of the economy (i.e. [their] financial assets greatly exceed their financial liabilities)."
Declining rates thus convey a warning about investing - traditionally "safe" investments have significant dangers of their own, including cash flow problems and narrow margins of return over inflation.
All savers are vulnerable to lower interest rates, but perhaps none more so than the elderly. Few elderly, comparatively speaking, have mortgages that they could refinance at lower rates, but many do receive interest payments on a "nest egg," from the sale of a home or years of dedicated saving, that they use to supplement the income they receive from Social Security.
The recent drop in rates has shown how drastic an income reduction can be for retirees who depend on savings income. For example, a retiree who placed $100,000 from the sale of his house in 3-month CDs earned about $5,830 (the average rate was 5.83%) in 1991. In 1992, he would have made only about $3,680 (3.68%) in interest - a $2,150 drop.
Low rates also leave these savers vulnerable to inflation. Historically there has been a narrow margin between interest rates on cash investments and inflation, about 1% to 1.5% during the past 40 years, reports William Reichenstein, an associate professor of finance, insurance, and real estate at Baylor University, in the September 1992 AAII Journal. The 1980s were an exception to this and saw rates average 3.26% more than inflation. During the 1990s this gap has narrowed dramatically; last year when the rate of inflation was 2.9%, the average return on a taxable money market fund was only .47% higher.
More startling was that by December 1992 the average taxable money market yield had dropped below the rate of inflation for the year - to 2.83%, according to IBC/Donoghue. This pattern has continued so far this year, with the average taxable money market fund returning only 1.1% through May (according to IBC/Donoghue), while the Consumer Price Index, a measure of inflation, increased 1. …