Really low interest rates

Interest rates are extraordinarily low and the Federal Reserve is keeping them that way. Yesterday the Fed lowered the target rate, otherwise known as the Federal Funds Rate, for overnight interbank lending to 1.0%.

The commentariat talks about the help that low interest rates provide to commercial and individual borrowers but largely ignores a group that suffers severely from interest rates significantly below the rate of inflation. That group is composed of savers – many of them elderly – who wish to avoid risk and who keep their money in FDIC insured bank accounts, money market funds, and certificates of deposit.

It is not just individuals, either, that are being punished. Many small businesses, clubs, condominium associations and other non-profit organizations have cash reserves which may be needed at short notice (liquidity) and safe (FDIC insured). The interest rates offered to these groups can best be described as pathetic.

Low interest rates transfer wealth from the prudent and thrifty to borrowers - some of whom are far from prudent.

Worse, everyone has agreed to pretend that all interest is real income, on which tax can justifiably be levied, when a large part of it is merely compensation for the declining value of money.

Since governments tax the nominal return, rather than the real (i.e. in excess of inflation) return, the result, except in extraordinary times, is a distorted wealth tax - rather than an income tax - with rates that increase with the inflation rate. So, in addition to the destruction of wealth caused by inflation, savers incur real tax bills on phantom income.

We may hope that Federal Reserve Chairman Ben Bernanke has learned from the mistakes of his predecessor. His objective must be to return interest rates to a normal level as soon as the present panic has ended. Since it is unlikely that the "geniuses" of Wall Street have learned any long term lessons, the risk of yet another asset price bubble is high if he does not.