How to crush retirees –1970s vs 2010s, or, QE3 kicks off

In the ‘70s it was inflation that crushed retirees. Today it is near zero interest rates.

Inflation rates in the late ‘70s and early ‘80s were terrible. The 1974 rate of 11.0% was just a hint of things to come.

The ‘70s method

In 1979 inflation was 11.3%, in 1980 it was 13.5%, in 1981 a mere 10.3%. Policies of a new administration and new chairman of the Fed brought it down to 6.2% in 1982 and it continued to slide an additional four years. Other than 5.4% in 1990, we haven’t seen 5% inflation since the Carter administration.

You can check out my data here.

In case you don’t recall that era, it devastated people who were living on a fixed income bond portfolio. When interest rates rise, the price of bonds fall. So the bonds you held during that time would have lost a tremendous amount of value. The interest earned would have stayed at the rates on bonds when you bought them but your purchasing power shrank a lot.

Cumulative inflation during those three years I mentioned would be 39.3%.

The impact of 39% inflation on a retirees living on a fixed pension was devastating.

The ‘10s method

Today it is an almost opposite problem. Interest rates are near zero. Check out your bank savings account or brokerage account if you haven’t done so lately.

Again the impact on retirees is severe. As bonds come due they are reinvested at near 0%. That means there’s no earnings to live on.

The cause?

We can debate the cause of the 1970s inflation if you wish. My opinion then and today is there were two problems. First, the shock of dramatic increases in oil prices. Second, government policies.

Today, the declared intention of the Federal Reserve is to drive interest rates down. We can debate how much credit/blame their intentional policies earn/deserve. Regardless, that is the intentional policy.

Yesterday the Federal Reserve announced QE3 with the declared goal of stimulating the economy by forcing interest rates down further. They will start with buying $40,000,000,000 of mortgage-backed securities per month. That’s pumping up the money supply $40 billion a month. They will continue as long as they think it is needed, but at least through 2015.

Almost every blog I read that touches on business, economics, energy, or politics discussed this yesterday. So as usual, I’m late to the party.

At lunch today I read the Wall Street Journal editorial which barely mentioned the impact on retirees.

In Bernanke Unbounded, they also described an unintended consequence that undercut growth their policy encouraged:

QE2 succeeded in lifting stocks for a time, but it also lifted other asset prices, notably commodities and oil. The Fed’s QE2 goal was to conjure what economists call “wealth effects,” or a greater propensity to spend and invest as consumers and businesses see the value of their stock holdings rise. But the simultaneous increase in commodity prices lifted food and energy prices, which raised costs for businesses and made consumers feel poorer.

These “income effects” countered Mr. Bernanke’s wealth effects, and the proof is that growth in the real economy decelerated in 2011. It decelerated again this year amid Operation Twist. When does the Fed take some responsibility for policies that fail in their self-professed goal of spurring growth, rather than blaming everyone else while claiming to be the only policy hero?

(Perhaps we should call Operation Twist QE2b. Maybe it was QE3a and this round is QE3b.)

The wealth effect stimulates the economy and the unintended consequence of income effect slows it down.

Will QE3 help the stock market? Sure. For a while. One commentator last night called it a ‘sugar high’.

If QE3 works, the unintended immediate consequences on retirees will be substantial and the risk for all of us from unwinding QE1, QE2, and QE3 will be increased.