Even before the Federal Reserve said it would keep interest rates near zero for at least three more years, Dan Bienvenue knew he had a battle on his hands.
As chief investment officer of the nearly $400 billion California Public Employees’ Retirement System (CalPERS), which provides benefits for 2 million current and future retirees, Bienvenue must earn an annual return of at least 7 percent.
That’s not easy when the safe investments that pension funds usually rely on are paying less than 1 percent, a consequence of low interest rates.
CalPERS, the nation’s largest public pension plan, fell short of its goal in the fiscal year that ended June 30. Now, along with embracing riskier investments like private equity, Bienvenue is gambling on making low rates work for him, by borrowing billions of dollars in hopes of juicing the pension plan’s returns.
“We have to take more risk in some places,” he said. “Systemically low interest rates, the net effect makes the challenge more difficult.”
CalPERS’ shift is just one example of how an era of persistently low interest rates has rippled across the economy, altering incentives while benefiting some groups and hurting others.
Consumers have snapped up zero percent auto loans and mortgages at sub-3 percent rates. That’s helped the economy by driving sales of new homes and automobiles.
Depressed rates also have fueled a rise in corporate and government debt, aggravated trends toward greater inequality and left a wounded economy more dependent on fiscal support from lawmakers at a time when Congress is intensely polarized.
Rates have been stuck at ultralow levels for most of the past 12 years because of chronically weak demand in the United States, Europe and Japan. The recovery from the 2008 financial crisis was the most anemic since World War II, and — despite President Trump’s claims to have produced the greatest economy in history — the U.S. economy grew at an average rate of just 2.5 percent from 2017 through the end of last year.
Aging populations, subpar productivity growth and a once-in-a-century global health scare led the Fed earlier this year to return its benchmark borrowing rate to near zero and to resume large-scale buying of corporate and government securities. Fed Chair Jerome H. Powell has said rates would remain near zero at least through 2023.
Once an emergency remedy for economic collapse, ultralow rates now are a fixture of the U.S. landscape. It may be a decade, perhaps longer, before they return to the levels seen in the 1990s and early 2000s, economists said.
“Yes, this is a very striking environment compared to the preceding 150 to 200 years of the modern economy, with the possible exception of the Great Depression,” said Adam Posen, president of the Peterson Institute for International Economics.
Today’s low rates reflect a shift in the way the Federal Reserve thinks about the economy. After a review last year, top Fed officials concluded that the neutral interest rate — one that neither spurs economic activity nor cools rising prices — is lower than they had believed.
With rates expected to stay low, the Fed will have less ammunition to fight recessions. In March, when the coronavirus pandemic plunged the economy into a sudden freeze, the Fed could reduce its key lending rate by just 1.5 percentage points, far less than the roughly 5 point historical average, Lael Brainard, a Fed governor, noted in a recent speech.
The Fed’s limited firepower leaves Congress with more responsibility for propping up the economy. House Democrats and the Trump administration have been locked for weeks in fruitless talks over a new round of relief spending.
“The risk here is a downward spiral,” Brainard said, warning that the economy could be trapped in a vicious cycle of low interest rates, muted inflation and weak growth.
Long-term trends such as disappointing productivity gains and limited labor force growth are sapping the economy’s potential. In July, the Congressional Budget Office said the U.S. economy could expand in the long run at an average annual rate of just 1.8 percent — down from more than 4 percent in 2000.
“It’s like a case of sclerosis,” said Nathan Sheets, chief economist for PGIM Fixed Income. “It seems everything in the economic body is slowing down and is functioning at a somewhat more restrained rate than it did 15 years ago.”
By lowering its benchmark lending rate, the Fed has made it easier for companies to obtain credit for job-creating investments. Its purchases of treasury securities early in the crisis helped ease bottlenecks in the market for U.S. government debt.
But like a lifesaving drug that carries dangerous side effects, the Fed’s low interest rate policy has complicated the job of managing the economy and raised risks to financial stability.
“There are real costs to keeping rates at zero for a prolonged period of time,” Robert Kaplan, president of the Federal Reserve Bank of Dallas, said in a recent speech. “Keeping rates at zero can adversely impact savers, encourage excessive risk taking and create distortions in financial markets.”
In November, the Fed warned that a prolonged period of low interest rates could damage the profitability of banks and life insurers and force pension plans to take bigger risks. The result would be to increase “the vulnerability of the financial sector to subsequent shocks,” the Fed said.
“There are fundamental reasons we are where we are. But there are unintended consequences,” said Kathy Bostjancic, chief U.S. financial economist for Oxford Economics.
The banking industry is a good example of the relationship between economic weakness, low interest rates and financial stability.
Falling interest rates meant banks charged borrowers less for their loans. The spread between what banks earned by lending and what they paid depositors for their savings — the net interest margin — fell to its lowest mark since the government began keeping records in 1984, according to the Federal Deposit Insurance Corp.
As a result, bank profits in the second quarter fell 70 percent from the previous three months. Bank stocks, measured by the KBW index, have recovered from the pandemic crash in March only half as much as the overall stock market.
Over the past two years, new deposits have far outpaced demand for loans, according to a Goldman Sachs analysis. That reflects both the Fed’s asset purchases, which have injected large amounts of cash into the financial system, and weak demand.
As banks parked much of that $3.2 trillion inflow in cash, which earned just one-tenth what they could make by lending the money to a good corporate credit risk, their profits have shrunk.
Banks have enough of a capital buffer to ride out a renewed economic downturn, the Fed said. But the risk is that an economic relapse would cause large numbers of consumer and business loans to go bad, eroding industry reserves and causing banks to restrict new lending.
“Financial stability is a first-order concern for the Federal Reserve and, going forward, a first-order risk for the U.S. economy,” said Sheets, a former Treasury Department official.
The Fed’s cut in short-term interest rates does not directly lower public borrowing costs. But investors seeking guaranteed returns this year have been willing to finance the government’s nearly $3 trillion response to the economic spiral. On Tuesday, investors asked just 0.64 percent to lend the government money for 10 years, a 59-year low in public borrowing costs.
Before the financial crisis, the government paid 5 percent.
These low rates mean that as a share of the economy, interest on the federal debt costs taxpayers a bit less today than in 2008 — even though the public debt has grown to more than $20 trillion from less than $6 trillion over that period.
By depressing the returns on risk-free U.S. Treasury securities, low rates also have encouraged investors to buy stocks. Since Dec. 16, 2008, when the Fed cut its benchmark lending rate to near zero for the first time, the Dow Jones industrial average, with dividends reinvested, has gained roughly 320 percent. That’s about five times what the iShares Core U.S. Aggregate Bond exchange-traded fund, a broad bond market proxy, returned over the same period.
The rise in stocks has benefited the already prosperous. The wealthiest 1 percent of Americans own more than $11 trillion of stocks and mutual fund shares, more than 70 times the total held by the poorest half of the country, according to the Federal Reserve.
The top 1 percent now own 52 percent of the equity in the United States, up from 42 percent when the Fed first dropped rates to zero. The bottom half of the country owns a slightly smaller share of all stocks than it did 12 years ago, according to Fed data. And small savers earn almost nothing from bank accounts or certificates of deposit.
Soaring stocks have led some analysts to warn of a financial bubble. Yet, the Fed really has no choice but to keep rates low. For all of its unintended consequences, easy credit represents the only escape from an era of disappointing growth.
“The policy has severe distributional consequences,” said Posen. “Small savers don’t do well. But these same small savers wouldn’t do well if central banks raised rates and more people were unemployed.”
Still, the low interest rate era is imperiling retirement security for millions of Americans, making it more expensive for public pensions to meet their promise of guaranteed income decades in the future. The problem is especially acute for funds like the Ohio Police and Fire Pension Fund, which continues to count on earning 8 percent annually. The fund declined an interview request.
The low rates era has pushed fund managers to shift more assets into “alternative investments,” riskier initiatives such as private equity, hedge funds and real estate. They promise higher returns than bonds, but carry larger risks as well.
At CalPERS, Bienvenue, who holds the chief investment officer title on an interim basis, is implementing a new strategy that aims for higher returns by using borrowed money and increasing investments in private equity deals, which could be harder to sell in a sudden downdraft than publicly-traded stocks.
The fund posted a 4.7 percent return for the fiscal year that ended June 30 and has averaged 6.3 percent over the past five years, short of what’s needed.
“Whether 7 is doable or not is an open question,” said Bienvenue. “Even with leverage and even with private assets, we acknowledge that’s a tall order.”