Robbing people with inflation

Interest rates in the US are now so low, and inflation rates are so high, that anyone who has put their money in an interest bearing account is losing money. This is an intolerable situation as it is essentially robbing people of their hard earned money and punishing them for being fiscally responsible.

According to summary tables from The Economist magazine, America's inflation rate is 5.6%, while the rate on ten year bonds is 3.75%. I'd hate to see what sort of interest rate is being charged on Commercial bank time deposits.

Many, including econ-blogger Mike Shedlock (Mish), are predicting that inflation pressures are short term and that the real long term problem will be a deflationary environment caused by the US subprime crisis.

While I agree that the subprime crisis and the credit crunch that has followed has a deflationary effect, I also believe that high oil prices and a low US Dollar have created an inflationary environment as well. More than that, I believe that the net effect of these crises will end up on the inflationary side of things. Moreover, I can see a stagflationary environment (5% inflation plus 5% unemployment) developing over the course of the year.

I have stated before that the credit crunch and the subprime mortgage crisis that preceded it were the result of lax fiscal and monetary policy in the US. I have written about America's developing fiscal crisis elsewhere, so today it is time for me to write about America's monetary problems.

It is almost a given today that the subprime crisis was caused by excessively low interest rates from 2002 onwards. Here is an important graph from the St Louis Fed:

As you can see, interest rates were reduced dramatically throughout 2001 as Alan Greenspan sought to limit the damage caused by the popping of the tech bubble. As a result, interest rates from 2002 until late 2004 were kept below 2% to stimulate economic growth.

But here is the same graph with inflation added:

As this second graph shows, inflation (the thin red line), exceeded interest rates from late 2002 to the end of 2005 - three years in which people's savings were eroded, three years in which people were punished for not spending the money in their wallet, three years in which people were encouraged to go on a credit splurge.

And it is that period which saw the housing bubble being inflated. Fortunately, growing inflation led the Fed to increase rates - a process that didn't stop runaway house prices until 2006.

To keep this in its historical context, let's look at how inflation and interest rates have performed since 1980:

You can see Volcker's interest rate hikes back there between 1980 and 1982, along with Greenspan's cuts from 1990 to around 1994. You can also see episodes where inflation outperformed interest rates - for a small time in 1980 and a period during 1994 where the rates pretty much matched each other. It has only been the 2002-2006 period that saw a long term period of real negative interest rates, along with post 2008.

It seems reasonably clear from this latter graph that Greenspan's rate cuts after the tech boom went way too far. The early 80s rate cuts and the early 90s rate cuts were far more staggered, while the 2001 cuts were like jumping off a cliff. It could be argued, therefore, that America's monetary policy, post-2001, has been dangerous, imbalanced and, well, incompetent. Not only was inflation allowed to exceed interest rates, but it created a bubble that, when popped, has resulted in yet another period of negative real saving.

In other words, what caused the problem is being used to solve it.

Since we're at a point now where stagflation is again a serious issue, it would be good to examine what real interest rates were during the 1970s, the period we all associate with high inflation and stagnant economic growth. Here is the 1965-1980 graph that matches the same information on the graph above:

So not only were there negative real interest rates between mid 1974 and 1978, but the 1978-1980 rates barely rose above zero. This period of history was punctuated by repeated recessions, the longest of which - the one caused by Paul Volcker's interest rate hikes - was needed to kill off inflation, a process that led to a very wide spread between inflation and rates and which resulted in reasonably high real interest rates throughout the 1980s.

I would argue that this data essentially proves a general relationship between recessions and negative real interest rates. Along with the 1954-1974 figures (which you can see here), there appears to be a causal relationship between the two. Moreover, the data also seems to suggest that whenever real interest rates are positive, and when these real rates are wide, the gap between recessions lengthens. This is not always true though, and my assertion is very much a generalisation because other factors come into play that are not taken into account in the graphs above.

Nevertheless I will point out that America's experience of negative real interest rates from 2002 to 2005 and from 2008 to today is very unusual. Moreover, Bernanke's interest rate cuts in late 2007 and early 2008 came at a time when inflation increased sharply. Since the Fed often acts to anticipate events, it could be argued that they were expecting inflation to fall sharply in 2008, something which has not occurred.

The US economy has only diced with negative real rates five times since 1954: 1957-1958, 1974-1980, 1994, 2002-2005 and 2008 (the last one is ongoing). The fact that the last two have occurred so quickly is what is so unusual.

Let me explain again what the problem with negative interest rates are: They punish people for saving while rewarding them for spending; they punish people for lending and reward people for borrowing; they punish people who are judicious and reward those who are careless. In short, negative real interest rates are a recipe for economic disaster.

This, in turn, is one reason why I have argued for years that central banks, including the Fed, should focus clearly on reducing inflation. Employment, which is of vital importance to society, and businesses, who make the decision to employ people, both need economic growth. But economic growth, to be sustainable over the long term, needs to have low inflation and positive real interest rates.

Balance is the key here. There is nothing wrong with spending just as there is nothing wrong with saving; there is nothing wrong with lending and nothing wrong with borrowing. Negative real interest rates, however, produce a severe imbalance in that area.

Serendipitously, Mish has just posted an article entitled "Real Interest Rates are High".

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