Learning to go past simple comparisons

The economic crisis over the past five years has thrown up many kinds of phenomena and concomitant policy puzzles. From "decoupling", "jobless recoveries", "moral hazard" and so on, ideas that were ‘theoretical' have come to the fore in real life. Each purports to explain parts of, or en masse, the origins of the crises, why it had been so deep, the consequences to the global economic order, etc. While such intellectual constructs slosh about, policymakers at the US Federal Reserve and US Treasury have held steady in one belief: the benchmark interest rates that they can control must remain as low as possible.

The idea is simple: when the cost of borrowing across the economy for various time horizons declines, presumably stalled economic activity will restart. Yet, for the first time, this past week, the Fed has come out in the open and announced that interest rates shall be around zero per cent for the foreseeable future; and has explicitly set an inflation target around 2 per cent. In the back of their minds, the reduced estimates of growth — somewhere between 2.2 per cent and 2.7 per cent — have influenced the decisions to keep rates low. The Federal Reserve and the US administration continue to believe that recovery in the housing market is essential and low rates are key.

All this may be fine in theory, but criticism of the Federal Reserve has begun to flow in. With a certain amount of unmistakeable irony, critics have railed against this excess of transparency. Ostensibly, this amount of candour would affect the Fed's freedom to pursue effective policy measures. In response to this critique, the supporters of the Fed policies have argued that what the economy needs is precisely a vortex of stability. If the government's policy stances are well understood in an uncertain economy, the argument goes, the rest of the economic actors will optimise their actions and efficiently allocate resources.

Residential mortgage

While it is too early to say if this is indeed the case, we already see signs of confident play in the residential mortgage market. For example, investment bank Credit Suisse recently bought residential mortgage-backed securities with a face value of $7.014 billion that the Federal Reserve had been forced to buy from the insurance giant AIG's subsidiaries. That other banks had been part of a competitive auction, and Credit Suisse has clients lined to buy from them reveals that the interest for such products is rising, thanks to the anticipation of an improved economy.

There is another critique of the Fed's policy. This argues that when interest creeps to zero the savers in the economy are disproportionately hit. The interest income they earn from their savings in bonds and other interest-indexed securities drop. Further, given a US government that borrows at such historic levels — it has become the largest payer of interest into the economy. So, when interest payments decline, the aggregate demand has in effect been stymied. Naturally, the next logical question is: do borrowers contribute more to the aggregate demand than the savers. [This is a riff on an old theme as to whether the propensity to consume from tax reduction is larger than from government spending during an expansionary fiscal policy.] The answer to this question is at best, uncertain.

What the critics of the Fed's policy say is that the decline in interest rates affects savers more negatively, while not really accruing any real benefit to the borrowers. Again, this is a contested claim. The key point, however, is their belief that the institutional structures that privilege borrowers in the present economic cycle do more damage by creating deflationary pressures.

Such straightforward comparison of dollar amounts between the savers and borrowers, by itself, is meaningless. What matters is how does money affect their welfare? It is almost facile to argue that the gains in welfare that the bottom quartile get from a reduction in their borrowing costs is equivalent to the loss in welfare that the top quartile of the population suffer through lowered interest income. It is a false equivalence. The Fed's policy to lower rates must be measured via not just simple linear comparison of whether the dollar amounts lost by savers cancel out the amount gained by the borrowers.

The jury is out. The early, and inconclusive, evidence is positive.

The columnist works for a European investment bank in New York City. All opinions are personal and don't reflect any institutional perspectives.