The debate over whether the Fed should keep or raise interest rates has enormous implications are enormous
As we await the spring return of hawks to the Snake River Birds of Prey National Conservation Area, we can watch economic Doves and Hawks battle over the proper level of interest rates.
The Doves are policymakers who see little inflation risk and want interest rates kept low to encourage consumer spending. Their opponents, the Hawks, say higher interest rates are needed to offset the risk of rising inflation.
The debate is worth watching closely as the implications are enormous. The consequences of increasing inflation are well known — lower real wages for workers, lower levels of investment and slower economic growth.
A policy of low interest rates is not inconsequential, even if inflation remains low. The historically low rates of the past few years impair the ability of pension, insurance and other savings plans to meet retiree obligations.
Recent indications of better economic growth — large corporate profits, rising stock prices, higher retail and existing home sales — suggest overall price inflation should be rising. The Doves are nonetheless winning the battle as inflation, both current and expected, is low.
Many commodities, such as gold and silver, experienced rapid price increases throughout the recession, but prices for all goods and services remain stable. The Consumer Price Index is only one half of 1 percent above its level in July 2008. The Fed’s preferred measure of inflation, the personal consumption expenditure index, is only 1 percent higher over the same period.
Inflation expectations, as measured by the difference between rates on two-year and 10-year U.S. Treasury notes, also are stable. This yield spread is now 2.8 percent (3.4 percent for 10-year notes and 0.6 percent for two-year notes), up from 1.5 percent before the financial crisis began in the fall of 2008. Since early 2009, however, the spread has held relatively constant between 2.5 and 3 percent.
Fed interest rates are likely to stay low unless current inflation jumps or the spread widens dramatically. In so doing, policymakers hurt pension funds and other savings plans.
Underfunded state pension funds in particular will face difficulty if interest rates don’t rise. Large pension programs like the California Public Employees’ Retirement System will attempt to overcome the low market rates by moving more and more money to riskier investments, such as commodities and hedge funds.
The alternative of higher taxes to meet existing obligations only adds to woes of slow economic growth.
The Public Employee Retirement System of Idaho is well funded, but this valuation depends on an investment return of 7.75 percent over the long run. With long-term bonds nowhere near this rate, PERSI will need to keep a significant portion of the fund in more risky investments.
The Doves are currently winning the battle, but the low-interest rate policy has done little to spur economic growth and has risks well beyond that of inflation.
Hawks along the Snake River always win. Perhaps the economic Hawks will win this debate as well.