The Federal Open Market Committee (or Fed colloquially) chaired by Ben Bernanke has released its policy statement today confirming Fed watchers’ expectations of a new bond-buying program. The new program already called QE3, for quantitative easing 3, will consist of monthly purchases of mortgage-backed securities worth 40 billion dollars for an indeterminate amount of time. So what are all the implications of such a program and how will it affect Americans in their day-to-day lives or how it may affect the rest of the world for that matter?
Firstly, the intent of QE3 is to stimulate the economy. Unemployment is high in the US and rate of growth of the economy is low, which means people are not as wealthy on average as they could be. The Fed lowers the interest rates in the hope of stimulating more investment and job growth. Consequently, more people will refinance mortgages at lower rates or new credit cards get approved at lower rates, which triggers more spending and are conducive to more investment in a business-friendly environment. However, the flip side is that the Fed is grilling savers. If you are working, earning a salary, and living on credit, such policies as QE3 are great! But, if you are retired and living on savings, the Fed’s action are tantamount to a kick in the teeth.
Imagine living on the interest of your hard earned savings. You are 73 and you had purchased an American government bond that matured in 15 years back in 1997, when it was yielding ~7% or so. You had saved money and sold your huge house for a smaller condo as your kids moved out raising a nest egg of $500,000 which you stuffed into the above mentioned bonds. You had been living of the $35,000 dollars worth of yearly interest quite well. Now it’s 2012 and that 1997 bond has matured, so you need to roll over your investment to continue getting interest to maintain your living costs. If you were to buy the same bond today maturing in 15 years, you would be looking at an interest rate of under 1.75% and revenue of just under $9,000 dollars a year. Even your Canadian Pension Plan cheque will be bigger, so you can forget Cuba and any other vacations you planned to take!
While this is a very specific and simplified example of the effect of the Fed’s policies on retirees, the damage is representative. This is not however the only harm being done to the economy and to ordinary citizens. There is a long laundry list of harms one could list here with regards to Bernanke’s ‘easy monetary policy`, especially since the 1990s inflation targeting has been the most widely adopted policy stance for central bankers. That is, central bankers have tried to create a financial climate, free of uncertainty, regarding the value of money. Rejecting the policies of past central banks made businesses confident that they could expect inflation of 2% every year, so that the value of their investments and efforts would not go down the drain through hyperinflation. Central to this expectation was the promise that inflation targeting was the only concern of Central Banks.
“If the outlook for the labour market does not improve substantially, the committee will continue its purchase of agency mortgage-backed securities”
From the FOMC press release, September 13th
Ben Bernanke has rejected this approach, as evident from the language in the FOMC’s most recent communiqué, which reads like a policy approach for employment targeting – something every economist has now rejected as impossible to achieve and absurdly counter-effective. Bernanke cannot receive all the blame for this approach as the Fed remains one of the last central banks to have a dual mandate of employment maximization and inflation targeting. Up until Bernanke’s tenure as Chairman at the Fed, the FOMC had been understood to prioritize inflation in order to obtain maximum employment in the long run. This policy of rejecting its mandate in all but name had serve greatly in establishing a well-anchored expectation of low inflation for the future. Already analysts are beginning to fret that inflation vigilantes are readying their knives and are dumping government bonds. If inflation were to rear its ugly head, expect to see retirees suffer doubly from the low interest policies. Not only will their interest income be insufficient to cover life expenses, but inflation will nibble away, if not chew away the value of that income.
Precious few of us remember the 70s and 80s and how stagflation, the combination of high inflation and low growth, hurt our economies in those years. It would seem the Fed is the first of many to have forgotten the ills of those times and does not fear their return. What should also scare today’s workers and savers is that there is no end in sight for these irresponsible policies. What has surely prompted the monetary policy shift in the US is the abdication of fiscal policy to Washington for resolving the problems of the American economy. Unless some economic rationality and hawkishness makes a return to the halls of power in the world’s greatest economy, I am not confident the troubles of the past 4 years will be remembered by history books as the bottom of the crisis.