The Investor’s Dilemma-21
Low interest rates and a very real possibility of price inflation mean that even relatively safe investments carry more risk. It’s an open question how the current mix of government policies will affect the picture.
by Kerry A. Lynch, AIER Senior Fellow, May, 2010
Faced with big losses in their 401(k)s, falling home prices, and rising unemployment, households are cutting back on spending and saving more.
The personal saving rate increased to 3.2 percent at the end of 2008, up from less than half a per cent in 2007. Uncertainty over the economy and the financial market has also led many to take a fresh look at relatively safe investments, such as Treasury securities and CDs.
Unfortunately for investors, the rate of return on these securities has been exceptionally low in recent months. The rate on five-year Treasury notes was just 1.86 percent in April. Three years ago, it was 5 percent, and just last August it was over 3 percent.
The rate on one-year Treasury bills has fallen even more—from 5 percent in 2006, to 2 percent last summer, to just 0.55 percent in April.
There are two major reasons for this decrease. One is the Federal Reserve’s extraordinary effort to flood the market with money and reduce interest rates. The other is investors’ flight to safety, which has increased demand for Treasuries and driven down their yield.
Adjusted for price inflation, the rates on Treasuries have been barely positive in recent months. In February, the real rate on five-year notes— calculated as the nominal rate minus the rate of price inflation over the preceding 12 months—was just 1.63 percent. The real rate on one-year bills was a minuscule 0.38 percent.
From the investors’ perspective, this was actually an improvement from last summer. At that time, interest rates were falling, but price inflation was surging, led by soaring prices for energy, food, and commodities. The rate of consumer price inflation topped 5 percent last July—well above the nominal rate on Treasuries. As a result, the inflation-adjusted rate on Treasuries turned sharply negative in the second half of 2008. This is shown in Charts 1 and 2 on the next page.
Now, nominal interest rates are lower than they were last summer, but real rates have rebounded into positive territory. The difference is price inflation. The Consumer Price Index actually fell throughout the second half of last year, as oil and commodity prices plummeted. In December and the early part of this year, the CPI was barely higher than it was a year earlier.
In March, the CPI was actually lower than it was a year earlier. In other words, the 12-month rate of inflation was negative. The drop was small, just -0.4 per cent. But, as can be seen in Chart 3 on the next page, any such decrease is highly unusual. The last time the CPI fell on a year-over-year basis was during the Eisenhower administration.
As a result, the real rate on one-year Treasuries increased to 1.02 percent in March, up from 0.38 in February. The real rate on five-year Treasuries rose to 2.20 percent, up from 1.63.
The Fed seems likely to do its best to keep nominal rates low for some time. Whether real rates are positive or negative, then, will depend largely on what happens to price inflation. Deflation would translate into positive rates; a return to inflation would turn rates negative again.
It is worth noting that real rates on one-year Treasuries were negative in 2003 and 2004 as well. The real rate on five-year Treasuries was somewhat higher back then but often close to zero. What this suggests is that investors looking for safety in recent years have had to settle for interest income that barely offset the loss in purchasing power of the dollar. Often it did not even do that. Faced with these low returns, many of them switched to higher-risk stocks in hopes of earning higher returns.
Now, the hope of policy makers is that low or negative real rates, by reducing the reward for saving to nil, will encourage people to spend instead of save, thereby reviving consumer spending and economic growth. But with nominal rates so low, there is little room to cut them further. Practically speaking, the only way to make real rates lower (i.e., negative) is for price inflation to accelerate.
In other words, the Federal Reserve might not be sorry to see the rate of price inflation increase. Their hope is twofold: that a little more price inflation might be a good thing for the economy, and that they can control any acceleration sufficiently to keep it from getting out of hand.
But as anyone who lived through the 1970s will remember, price inflation can slip out of control. What seems like an acceptable tradeoff in the short term—printing money to cover budget deficits and stimulate the economy—can eventually blow up. And the costs of fixing the resulting mess can be high. It took Paul Volcker’s decision to let interest rates rise to double-digits to rein in the galloping price inflation of the late 1970s.
It is an open question how the current mix of policies will affect future price inflation. In the short term, the inflationary pressures of expansive monetary and fiscal policies might be offset by the deflationary pressures from global recession, weak consumer demand, and declining wealth.
However, the continued extraordinary interventions of the Fed and the Treasury in the financial system, coupled with projections that the national debt will double in the next 10 years, raises serious concerns about the risks of higher price inflation down the road.
In any event, investors will continue to confront a dilemma. To enjoy the safety of “low-risk” Treasuries, they must risk the possibility of returns so low that they don’t even keep pace with price inflation.
Translated by Alex Vlasenko
apvlasenko@gmail.com
apvlasenko.blogspot.com
1AIER, RESEARCH REPORTS, 17 May, 2010
