How The Fed Has Slowed The Recovery

by: Rich Rezny

Would you believe that since 2007, the number of people in the 65-74 year-old age group that have jobs -- all of them over the retirement age -- has actually increased by almost 1.4 million people?

That is 0.93% of a labor force that has an unemployment rate of 7.8%.

The economy as a whole has actually lost about 3.4 million jobs since 2007.

The financial crisis has been with us for almost a half decade now. The Federal Reserve has responded by lowering the fed funds rate to historical lows and has committed to this policy for years to come. Common wisdom says that lowering interest rates will spur investment because it makes financing cheaper. But what if low rates have led to unintended consequences that may be holding the economy back in some way? After all, the interest rate is just a price in a market -- to some it is revenue and to others an expense. Manipulating interest rates affects both sides of the coin.

The problem with the argument that low rates spurs growth is that it does not account for the second side of the coin -- interest is income for some parties. These parties lose out when interest rates go down to 0%. Interest is income for banks, insurance companies, and many people near or in retirement. This article will focus on the latter.

Interest As Income

A thorough explanation of the state of banking can be found here. Because depositors are already getting the floor of 0% on their deposits from banks, any further decline in interest rates for mortgages, commercial loans, or securities (this is interest revenue for banks) will only squeeze bank margins. Banks as intermediaries will find a way to deal with compressing margins -- some have even begun charging negative interest to certain depositors. Banks have been trading at less than book value because of low margins.

Insurance companies rely on interest earned on collected premiums to provide revenue. When costs go up and interest rates are low, then insurance companies need to make up the difference by charging even more in premiums. For instance, a 2011 Kaiser Foundation study found a 9% increase in premiums. Insurance companies are also intermediaries and will find their way in this market. If they need to raise premiums they will, but that does not help the real income of consumers who need to spend money on insurance, which is a large share of GDP.

Earning Close To 0% On A Nest Egg

A large economic current that may be overlooked in this environment as alluded to above is the effect of the interest rates on near or already retired people. This large saver group is not earning any significant interest income on their nest eggs, particularly at a time when their equity in their home has been hit.

Consider the following comparison of total personal income from 2008, when the crisis started, and 2012, taken from official US accounts:

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Add corporate profits to this total personal income figure and you get total GDP, which is about $15 trillion. As you can see from the chart, total personal income has gone up since 2008. Inflation occurred and there was some growth. However, look at total personal interest income, only one of just a few categories to actually have declined since 2008. It has gone down significantly, by approximately $400 billion. This is about 2.5% of total GDP! It has been the low interest rates that have caused this. You can't spend what you don't earn; interest is income to as many people as it is an expense.

So who are the people that receive interest as income and are losing out the most because of this Fed policy?

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As you can see, older age groups earn the most interest income. In fact, the 55+ age group earns 72.6% of the entire population's personal interest income. It makes sense -- they have the biggest nest eggs and are likely allocated into fixed income as they are near or in retirement.

The problem is that these people are feeling the pressure, not only from recent declines in real estate, but also a nest egg that is earning paltry returns as they prepare for retirement. As a result, many older workers are staying in the workforce and clogging up the labor markets for younger workers. You can see by the two graphics below that older workers are increasingly concerned about their retirement and are planning to stay in the labor market as a result.

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As you can see, older workers now expect to stay in the workforce longer. In fact, older workers have voted with their feet and have stayed in the workforce in droves per the original chart above.

The Zero-Interest Policy's Impact On Younger Workers

Baby Boomers' aging has resulted in greater numbers of people entering the 65-74 year-old group recently. A better indicator might be the labor participation rate for this group, which has also risen since the start of the recession (unlike the decline seen by other age groups). The result of these trends is more 65-74 year-olds in total, and a greater portion of them are still in the labor market, past their retirement age. Both trends do not bode well for younger workers.

The congestion caused by older workers not leaving the workforce has led to significant unemployment levels for lower age groups. In fact, per below, the unemployment rate gets progressively worse as age declines.

Younger workers are the ones who bring new equity into real estate markets and purchase durable goods at higher rates than other age groups. It is no surprise that these are the two industries that are lagging in the economy today. However, young workers can't save for a down payment if they don't have a job. They can't obtain jobs if older workers choose to stay in the workforce and clog the natural employment flow. Older workers have chosen to do this, in part, because their nest eggs won't earn them enough money in retirement. The interest rate has a direct effect on incomes of people in retirement.

Real estate and durable goods are the two accounts most hit by the downturn, and younger people who are very active in these markets have the highest unemployment rate of any age group. Consider the following:

As you can see, young people are hurting and becoming homeowners at lower rates than before the crisis. Further, as a result, they are making up a lesser share of total owned dwelling expenses. They are more unemployed than the other age groups and have been hit most by this crisis. This is the reason that the real estate industry is in a slump. It is not helping that older workers are staying in the workforce in large numbers.

I suspect the Fed intellectually thinks that it can get away with its zero-rate policy as long as inflation is in check. However, it is more complicated than that. A large share of people rely on interest as income. When interest income is low and the Fed commits to keep it low, then that affects expectations of future income and the ability to finance retirement. As a result, there are many people staying in the workforce, which ultimately affects younger workers on lower rungs of the labor market. Younger workers are the people that buy real estate and durable goods as they begin their careers and start families. If these younger workers don't have jobs, then they can't save for down payments or make big purchases.

The economy is more complicated than "lower interest rates and watch inflation." Manipulating prices in any market is dangerous because there are a variety of unintended consequences that could occur. In this case, the interest rate serves a very important pricing role of allocating consumption across time. This has led to real changes in behaviors regarding retirement, per the above, that has ultimately adversely affected the spending behaviors of the very people whose behavior that the government originally wished to stimulate.

Lower bound interest rates have already demonstrated themselves to be ineffective in stimulating the economy. Higher interest rates, all things being equal, will allow older workers to retire quicker, ultimately opening jobs up for younger workers who can save for down payments and make bigger purchases, driving the economy out of its sluggishness.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.