Monday, January 30, 2012

How Real vs Nominal Rates Affect Your Wealth

First I want to talk a little about real vs. nominal interest rates and how it affects your wealth. Then I’m going to tie the Fed’s zero interest rates policy (ZIRP) in and discuss how this policy is extending the recession/depression.

Real Interest Rates
You may have heard the expression before, “It’s not what you make, but what you keep”. Usually this is referring to taxes which can eat up your earnings and make it more difficult to preserve or create wealth. But there is another thief after your money: inflation. When you earn a 10% rate of return, you may be satisfied that your investments are working. This 10% return is called you NOMINAL RATE. But is that a good return? Perhaps. If the rate of inflation is running at the historical average of about 3% then your REAL RETURN is 7%, the difference between your nominal return of 10% minus the 3% inflation that eats up part of your return. But what if the inflation rate is actually running at 8%? Then your real return is only 2%. That doesn’t sound so great.

CPI Adjustments
Shadow Stats is an organization that tracks inflation using the former government methods that have now been modified to account for substitution and hedonics. First, substitution refers consumer behavior that recognizes that people who prefer steak will buy steak until it becomes expensive (as it has in recent years). These people, faced with higher prices may then substitute hamburger as a less costly alternative. If that becomes too expensive, they will substitute cheap hotdogs or maybe peanut butter. This type of adjustment does not recognize a decline in the consumer’s satisfaction nor their lower quality of life. Ironically, the second type of adjustment, Hedonics, does but in the opposite way. When you can buy a new computer for $1,000 dollars but it has more computing power than last year due to a faster processor, the CPI is adjusted to reflect you are buying “more” for the same money. The net results of these adjustments have been to artificially lower the CPI since both the 1980 and 1990 changes. From Shadow Stats : “In general terms, methodological shifts in government reporting have depressed reported inflation, moving the concept of the CPI away from being a measure of the cost of living needed to maintain a constant standard of living. “

REAL, Real Interest Rates
Getting back to our example, the Fed has reported that the CPI has been zero to 2% over the last few years. This is why people on Social Security have gotten little to no increase in the past few years. In our previous example a 10% nominal return would have a real return after inflation of 8-10%. Sounds great. But as Shadow Stats reports, using the older methods, inflation has actually been about 6% using the 1990’s method and around 10% using the 1980’s method. So your 10% nominal return had only a 4% return using the 1990’s CPI method. Not so great. Worse, under the 1980’s method you real return was ZERO! 
Consider that most people have not experienced double digit returns in the last few years either because they hold bonds and cash in their portfolio or because they are just parking their cash in banks and earning 0-1%. This would imply that most investors and savers are actually LOSING money in real returns when the older CPI calculations are used. As of January 27th, 2012, Morningstar shows that the S&P 500 returned just 3.45% last year, .6% over five years and 3.53% over the last 10 years. Clearly, long term investing is not working the way it did in the 80’s and 90”s.

The Federal Reserve's interest rate price-setting board, the FOMC, met last week. They will continue to set the federal funds rate at well below 1%, and plan to keep it low until the end of 2014. That's a year and half longer than they planned when they met just last month. Chairman Bernanke says they are keeping interest rates so low for so long because the economic outlook warrants it.
The fallacies in their reasoning would be amusing if they weren't so dangerous. The Fed wants to keep the price of money at essentially zero – in other words "free" – to boost the economy. But the boost they are attempting won't get here for another three years. That's not a recovery. And we've already tried this tactic. That's how we got into this mess in the first place: with interest rates artificially low for a very long time. Free money doesn't stimulate growth, as Japan's two lost decades clearly show. Artificially low interest rates only serve to punish saving, distort market signals, and cause further malinvestment. They also do nothing to address the only real solution to our economic woes: liquidation of the bad debt that hangs around the neck of the world's economy, preventing recovery. Artificially low interest rates merely ensure that we remain a debt-financed consumer economy guaranteed to end up with a weaker economy and higher prices.

Dr. Paul is absolutely correct on this. Why we would follow Japan as a model is beyond me as they have been in essentially a depression that has last 20 years. They’ve had ZIRP for almost that entire time and propped up “Zombie Banks” just as we are doing today. Why would we expect have different results? These are the policies of the Keynesians who believe that we can moderate the ups and downs of the economy through monetary stimulus just as President Obama tried in 2009. The results are clear: none of the real problems have been solved and the economic recovery is anemic at best. Though the unemployment rate has declined it is due almost entirely because people are dropping out of the workforce. The labor participation rate is the lowest its been since 1984 even as the number of people on food assistance hits all time highs.

So what IS the answer? Once again Dr.Paul, of the Austrian school of economics, has the answer from history:

Treasury Secretary Andrew Mellon was correct in the 1920s when he said "liquidate everything." That's what we did in the severe depression of 1920-21, and we recovered so quickly it is never even talked about. We didn't take his advice after the 1929 crash, and ended up with the Great Depression. We are committing the same mistakes, destined to live in this Great Recession for a decade or more—it has already been four years, the Fed says it will be at least three more! It's time we start rethinking what the Fed's policies are really doing to our economy, because obviously, by their own admission, they haven't helped.

To sum up, the Fed's ZIRP policies are extending the recession/depression by providing a disincentive to invest and save which limits new capital formation. As long as we "extend and pretend" and banks keep their massive non-performing assets on their balance sheet we will not have the type of new business expansion that would lead us to a strong recovery. Negative interest rates are NOT the result of free markets and actually creates all the wrong incentive needed for a recovery.

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