Feeling insecure with low interest rates

As the Euler equation begins its descent into history, where will we go from here? Well, we must understand the social psychology impacting consumption. It is not always true that higher interest rates leads to less consumption and more saving. Just look at the financial repression in China, where higher returns to savings increase consumption.

3 basic effects on consumption…

1. Higher interest rates by themselves lead to less consumption.
2. Income uncertainty leads to less consumption.
3. Uncertainty about the broader economy leads to less consumption.

There are more effects on consumption but just these 3 can work against each other.

Scenario #1…

1. High interest rates…
2. High degree of Income certainty…
3. High degree of certainty about the future of the economy…

1 suggests less consumption, but 2 and 3 suggest more consumption. This scenario roughly explains some of the 1980’s and 1990’s. A high degree of certainty about the future stability of the economy and banking system helped support consumption in a time of higher interest rates. The relative strength of each effect must be weighed to know if consumption will decrease or increase.

Scenario #2…

1. Low interest rates…
2. Low degree of income certainty…
3. Low degree of certainty about the future of the economy…

1 suggests more consumption, but 2 and 3 suggest less consumption. This scenario roughly explains where we are. Uncertainty about income and the future look to be over-powering the effect of low interest rates to spur consumption.

So what can be done to make people feel more secure about their future?

• Low interest rates are a signal that intensifies uncertainty about the future. The Fed’s forward guidance for low interest rates for many years creates concern. So, raising interest rates with a “forward guidance” message of confidence would create security that the economy is getting back on its feet.
• Stagnant wages create income uncertainty. So, increases in wages like the proposed increase in the minimum wage would lead to more consumption.
• The power of banks take away the power of “regular” people, who feel vulnerable. Banks seem to have even more power now, even after they damaged the economy. So, strong regulation of the banks, like was done during the Great Depression, would give back to people a sense of economic power and security.
• The chaos in the government makes people uneasy. So, the government has to learn to stop their silly games. The government has to get out of bed with “financial despotism“.

The point is that low interest rates should not be expected to simply increase consumption. There is a powerful social psychology of security at work behind consumption too.