US Federal Reserve Chairman Janet Yellen has made it clear the central bank will probably raise its target interest rate later this year. While some economists and the IMF may question that decision, US savers would welcome any change after five years of piddly returns.
The last few weeks have reminded everyone how volatile markets can be. For anyone who wants to avoid the turmoil, the only option is low risk assets that don’t even keep up with inflation. It’s a stark choice: more risk than they’re comfortable with or negative real returns. In that light, higher rates seem like a welcome reprieve. But savers shouldn’t get too excited. Healthy returns seen in the past are likely gone for the foreseeable future.
The pressing question is whether the low rates do really reflect the market price for risk or if the government interfered so much it robbed savers of their rightful returns?
For decades savers could get both returns and safety. The figure below is the three month-treasury bill rate (which closely follows other liquid short-term rates) over the last 40 years:
In 2001, a one month CD paid 5%; you’re lucky to get that from a junk bond these days.
But moving investors into riskier than desired assets has serious consequences. Pushing soon-to-be retirees into riskier assets may lower their retirement consumption and distort their saving and investment decisions. Low rates also diminish the incentive to save, leaving households with a smaller financial cushion to protect themselves from risk. It also encourages pensions and insurance companies into riskier assets that may come back to bite tax-payers.
Economists fiercely debate whether or not monetary policy has kept rates artificially low for too long. We can’t definitively say who is right here because we can’t observe the natural interest rate, an equilibrium to which all short term rates are supposed to tend toward.
Still, there are compelling arguments that rates are naturally lower than they were in the past. Regardless, even if the Fed raised its target rate 100 basis points (a full percentage point) this year savers won’t get a 7% CD rate. A rate hike later this year is good policy if it puts Fed rates in line with the slightly higher natural rate and it re-enforces the Fed’s credibility. But savers probably won’t see a big difference.
Even so, savers should feel cheated and demand more from the government. Low risk-free rates offer little incentive to save at a time when many Americans need to be socking away more. The best way to achieve higher rates is through more growth, which increases the return on capital. From that perspective, savers should back fiscal policy that promotes growth, namely well-chosen infrastructure projects, simplifying the tax codes and regulations, and increasing the duration on the debt it issues, which will help raise long term interest rates.