Low savings, high debt and interest rate policy

As you know, the CPI registered a whopping 5% yesterday. Year-on-year inflation hasn’t been this high since the Gulf War. So much for the ‘Great Moderation.’ But the increase in inflation begs another question: why are interest rates so low?

The Fed Funds rate is 2%. While it is unlikely to hit the 1% level we saw after the last bubble popped under Alan Greenspan, it is certainly very low — 3% under the current level of inflation.

A few weeks ago, I showed a graph of savings and debt (on the right). Basically, this graph demonstrates as well as any the moral hazard and perverse incentive structure provided by the asymmetric policy response run by Alan Greenspan and Ben Bernanke. Raise rates slowly on the way up after the bubble has already happened; lower rates aggressively on the way down to prevent pain in the bubble’s aftermath.

Because of the ‘Greenspan/Bernanke Put,’ Americans know that they will not be rewarded for saving, but rather that they will have their debt eaten away by inflation during economic downturns. So when push comes to shove, Americans have not been willing to reduce debt levels during economic downturns. Why would you? If Fed Funds is 3% under inflation, it seems silly to park your money in a money market fund and have inflation eat away at your savings. So, as each downturn has occurred in the past 20 years, Americans have failed to cut back enough to shore up their personal balance sheets, banking on asset price increases to do the heavy lifting during the next upswing. This is one reason the relative size of the financial sector and its importance has continued to grow and grow.

This madness has got to stop. Yes, we have an economic downturn. Yes, the financial sector risks a systemic collapse. And, yes, inflation is eating away at all those debts. But, when will the U.S. become a country that rewards saving? With the Federal Funds Rate at 2%, this is unlikely to happen any time soon. One begins to think these policies are adopted to keep the gravy train going for the financial services sector, while average citizens are left to fend for themselves.