The Economy by Peter R. Crabb: How Fed bond-buying hurts PERSI, other pension funds

PETER R. CRABB, professor of finance and economics at Northwest Nazarene University in NampaJuly 30, 2013 

Peter R. Crabb

Camping in Idaho’s beautiful wilderness this summer, I saw many hawks soaring our skies and hunting prey. It was amazing to watch them at work.

Meanwhile, the economic hawks at the Federal Reserve are losing their battle.

Economists use doves and hawks as labels when discussing monetary policy and bank interest rates. The doves are policymakers who see little inflation risk and want interest rates kept low for a long time. The doves also want more Fed purchases of long-term bonds to encourage consumer borrowing and spending. The hawks say higher interest rates are needed to offset the risk of rising inflation, and long-term bond purchases create financial instability.

Janet Yellen, the Federal Reserve vice chairwoman and a possible successor to Chairman Ben Bernanke, is seen as a dove. Yellen regularly expresses deep concern about the nation’s high unemployment and less concern for inflation.

Conversely, Kansas City Fed President Esther George is a hawk. George says the Fed has kept interest rates too low for too long. Further, she thinks bond buying is a bad idea, that monetary policy is “overly accommodative” and that the bond purchases are “causing distortions and posing risks.”

The doves are winning this debate for now because inflation is low and expected to remain so.

The U.S. economy has grown since 2009, and indications of better growth suggest that overall price inflation should be rising. Corporate profits remain strong, stock prices have returned to pre-recession levels, consumer spending at retail stores is good, and home sales have rebounded.

Despite these indicators, prices for all goods and services remain relatively stable. The Consumer Price Index is rising at a rate of only 1.8 percent a year. The Fed’s preferred measure of inflation, the personal consumption expenditure index, is up only 1 percent.

Inflation expectations, as measured by the difference between rates on two-year and 10-year Treasury notes, are also stable. This yield spread is now 2.2 percent (2.5 percent for 10-year notes and 0.3 percent for two-year notes), higher than before the financial crisis but down from 2.7 percent in 2009.

A policy of low interest rates is not, however, inconsequential, even if inflation remains low. The Fed’s policy of the past five years impairs the ability of pension, insurance and other savings plans to meet their obligations.

Underfunded state pension programs face great difficulty if interest rates don’t rise soon. Large state and municipal pension programs attempt to overcome the low rates by moving money to riskier investments, such as commodities and hedge funds. The importance of keeping government pensions properly funded and earning good returns is all the more evident since Detroit filed for bankruptcy, in part due to its financial obligations to former employees.

The Public Employee Retirement System of Idaho is well funded, but its valuation depends on an investment return of 7.75 percent over the long run. With long-term bonds nowhere near this rate, PERSI has chosen to keep a significant portion of the fund in riskier investments. As of July 2013, PERSI has only 25 percent of its $13 billion fund allocated to bonds, compared with a stated benchmark allocation of 30 percent.

So questions over monetary policy and interest rates create uncertainty in financial markets. The markets and those who depend on them, like retirees, would be better served without so much intervention. Let’s let doves and hawks go back to doing what they do best: flying.

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prcrabb@nnu.edu

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