This article was originally published September 30 by Dow Jones Newswires.
In the Fed's zeal to try to stimulate the market through a retread of the so-called Operation Twist, this nation's central bankers seem to have stepped into a realm where No Good Deed Goes Unpunished. In addition to the long bond dropping in yield 40 basis points in the wake of the announcement that the central bank will buy long-term Treasuries, broad equity markets have dropped some 6%. Some sectors, notably financials, have fallen even further.
That the patient has responded violently to the medicine of Dr. Bernanke and team reflects the realization that the cure may be worse than the disease. As we near the zero bound for interest rates, the usual rules do not apply--the second order side effects now dominate and cause more harm to the patient than good.
In its attempt to stimulate borrowing by making long-term money cheap, the Fed has harmed large swaths of savers. A look at three groups in particular proves instructive: pension plans, life insurance companies, and households saving both inside and out of 401(k)s.
Corporate pension plans are required to mark liabilities to market and fund accordingly. Because future benefits can stretch out for decades, the present value of their liabilities is very sensitive to changes in the long bond yield. For every percentage point drop in yield, the cumulative funding deficit of pension plans rises by roughly $220 billion to $240 billion dollars. Given this, the Fed's announcement and market reaction has added roughly $80 billion to $100 billion to a funding hole that was already a chasm. Companies in turn must now add an additional $12 billion to $15 billion per year to their plans to address the shortfall on top of the roughly $400 billion already slated to be contributed over the next five years.
Public sector pensions do not mark their liabilities to market like private sector plans. If they did, the increased funding hole would be on the order of $200 billion. They discount liabilities by an assumed rate of return on assets which is stickier than market rates. This is almost universally 8%. Given their asset mixes and the current yield curve, to realize these numbers would require a forward-looking long-run equity risk premium of nearly 10%. Barring something truly remarkable, in time these plans, too, will be showing the strains of very low rates.
Life insurers are hampered by low rates across a number of product lines. The gap between current book yields averaging roughly 5% and those available in the market currently will cause book yields to fall roughly a quarter percentage point or more per year on average and weigh on earnings. Fixed annuity business faces many similar challenges to pension funds, and as sufficiently long bonds do not exist to hedge the far off future liabilities, maturing debt needs to be re-invested at rates below those in force when policies were sold. Further still, given that the imbedded fees in variable annuity contracts for guaranteed benefits and charges typically run to 2.5%-3.0%, these products are not economically viable in the current rate environment.
Although households do not make the same calculations in thinking through their saving for retirement, they too face the same economic problems. The cost of consumption in retirement is now higher. Each dollar saved now will be worth less in the future. To meet their goals households need to save more, work longer, and consume less. Household savings rates have already rebounded from historical lows to 5%, but our models indicate their desired savings rates are 4% to 5% higher still. They cannot afford to save as much as they want or need. This will hamper growth and keep unemployment persistently high as those nearing previously normal retirement ages stay in the workforce longer than they would desire.
In addition to the damaging--although surely unintended--consequences cited above, the Federal Reserve's actions are likely to pressure bank earnings as net interest margins shrink. Reduced earnings potential is last thing damaged financial institutions need as they seek to rebuild capital and will crimp credit creation among small and medium sized businesses who need the banks for financing.
As the Treasury yield curve collapses, comparisons to Japan become more meaningful. The yield move has signaled that the U.S. is most likely in a "liquidity trap" in which monetary policy becomes increasingly impotent with respect to its primary objective of boosting growth and employment back towards potential.
As the market response demonstrates, the costs and risks of further extraordinary monetary policy action have risen relative to the prospective benefits. Chairman Bernanke should communicate what the market suspects; the Fed is running out of tools, and additional prescriptions to mend our economic trajectory will need to come from fiscal policy and structural reforms, not monetary policy.