- The Federal Reserve is trying to promote credit creation in the short term through Quantitative Easing - paradoxically, longer term consequences will produce deflation.
- Over-leveraged consumers combined with an aging population calls for an economy that promotes higher savings rates.
- Monetary policy will be less effective in stimulating economic activity due to structural changes within the economy.
The Fed's controversial Quantitative Easing (QE) stimulus program has strengthened financial asset markets without providing much lift to the broader economy. Many people are concerned that excessive money printing by global central banks will lead to inflation and put the US economy at risk of crashing. The idea is that the Fed will lose control of markets and the economy as inflation rates spiral higher. However, I do not share that concern. I feel the Fed is at risk of losing control of the economy over a longer term horizon, but in a different way and for opposite reasons.
US consumption is responsible for roughly two thirds of US GDP growth each year. That statistic is not alarming per se, but over a longer horizon it does make a difference as to how that consumption has been financed (perhaps a mixture of savings, increased wages or credit, etc). The problem is that consumption is generally not being financed by savings and increased wages, but rather through credit creation. Indeed, over the past two decades, the US economy has become increasingly creditized. At the end of 2009, 72 percent of Americans had at least one credit card. In fact, the growth rate of credit card debt per household has far exceeded the growth rate of household incomes.
As consumers run up ever larger amounts of debt to finance consumption, they become more constrained financially and less responsive to changes in monetary policy (i.e. interest rates). People with large credit card debt often do not have interest in borrowing more, at any interest rate. Indeed, with this explosion in credit card growth, we have seen a steep rise in credit card delinquencies. In fact, roughly one third of Americans have debt in collections. Consumers with high debt to income ratios and/or debt in collections are unlikely to alter consumption habits in meaningful ways due to changes in monetary policy.
Low interest rates for prolonged periods led to the financial crisis in 2007-08. It encouraged borrowers to become over leveraged and it encouraged consumption at the expense of savings. Low interest rates encourage people to become highly indebted. The long run health of the US economy depends on consumers bringing debt to income ratios back to sustainable levels. Instead, the Fed's low interest rate program is specifically designed to do the opposite; low interest rates are intended to discourage saving and increase borrowing, even as we've seen meager increases in real wage rates.
Quantitative easing has also exacerbated the problem of saving for retirement. Many Americans do not save enough for retirement and "the average working household has virtually no retirement savings." So with Federal government entitlement programs such as Social Security and Medicare set to come under increasing financial strain over the coming decades, we find that Americans have not decided to save more for retirement. Indeed, the underfunded status of most state pension funds is also alarming. Additionally, some of these large state pension funds such as CALPERS assume unrealisticly high returns over extended periods.
I think QE is exacerbating the low savings problem as individuals discount the future too highly and are implicitly discouraged from saving by Fed monetary policy. As ever larger groups of retirees pull out their calculators to discover the savings shortfall ahead of them, they will begin to reduce consumption. In preparation for retirement, they will increase savings regardless of what interest rates are since they will need safe assets as retirement looms. The consumption behavior of this increasingly larger cohort of the population will become effectively unresponsive to Fed policy. As seen in the chart below, the number of Americans 65 and older increases rapidly during the 2020 2030 decade.
I believe as we approach 2020, more and more people will reduce consumption in favor of savings and this will be highly unresponsive to interest rates set by the Fed. Consumption levels will fall as will US economic growth; perhaps significantly.
The US needs higher savings rates and that could be encouraged through higher interest rates. The 2007-08 crisis led to a balance sheet recession; consumers and businesses were less responsive to changes in the policy interest rates as their main focus was reducing debt and repairing balance sheets. That is the reason the Fed's low interest rate policies of the past several years have been ineffective at generating robust economic growth. Real wages need to rise or savings need to increase in order for balance sheet repair to gain traction at the consumer level. We haven't seen much of either thus far over the past six years, which is why economic growth still remains sluggish and consumers remain over-leveraged.
In summary, the Fed's QE policies are discouraging savings and encouraging consumers to remain over-leveraged, which will support only moderate economic growth in the short term. However, these same QE policies that are praised by some, are unwittingly exacerbating the medium to longer term structural problems that continue to simmer beneath the surface. The official decision to keep interest rates low for an extended period in order to encourage short term demand is going to lead to significant economic damage in the medium to long term. Rather than addressing the credit binge of the past two decades, and promoting policies that encourage people to bring credit to income ratios back to more sustainable levels, Fed policy has encouraged further borrowing and dissaving!
The US economy needs higher savings rates and lower debt levels, so when large baby boomer cohorts begin shifting their habits away from consumption and toward savings, there will be other viable (less indebted) demographic groups who could be encouraged to step in to fill the economic consumption gap. Current Fed policy is short sighted in nature and does not account for the longer term challenges that will surface due to suppressing the savings class. The next crisis is not going to be due to excessive money printing driving inflation higher; it's going to be due to excessive money printing which effectively keeps savings too low and will ultimately lead to deflation.