Full text of Inside the Vault : Spring 2011

The full text on this page is automatically extracted from the file linked above and may contain errors and inconsistencies.

Volume 15
Issue 1
Spring 2011

A n E c o n o m i c E d u c at i o n Ne w s l e t t e r f r o m t h e Fe d e r a l Re s e r v e B a n k S t. L o u i s

Shutterstock; Palis Michalis

Low Interest Rates Have Benefits
…and Costs

What’s Your
Question?
Inflation and
Deflation

Economic
Snapshot
CPI and
Core CPI

Bulletin Board
Third National
Economic Education
Video Competition

Resources
The Economic
Lowdown

www.stlouisfed.org/education

In late December 2007, most economists realized that the economy was
slowing. However, very few predicted an outright recession. Like most
professional forecasters, the Federal Open Market Committee (FOMC)
initially underestimated the severity of the recession.
In January 2008, the FOMC projected that
the unemployment rate in the fourth quarter
of 2010 would average 5 percent. But by the
end of 2008, with the economy in the midst
of a deep recession, the unemployment rate
had risen to about 7.5 percent; a year later, it
reached 10 percent.
The Fed used a dual-track response to the
recession and financial crisis. It adopted
some unconventional policies, such as the
purchase of $1.25 trillion of mortgage-backed
securities. And the FOMC reduced its interest rate target to near zero in December
2008 and indicated its intent to maintain
a low interest rate environment for an
“extended period.” Recently, some economists have begun to discuss the costs and
benefits of maintaining extremely low shortterm interest rates for an extended period.

Benefits of Low Interest Rates
In a market economy, resources tend to
flow to activities that provide the greatest
returns for the risks the lender bears. Interest rates (adjusted for expected inflation
and other risks) serve as market signals of
these rates of return. Although returns will
differ across industries, the economy also

has a natural rate of interest that depends
on factors such as the nation’s saving and
investment rates. When economic activity weakens, monetary policymakers can
push the interest rate target (adjusted for
inflation) temporarily below the economy’s
natural rate, which lowers the real cost of
borrowing. To most economists, the primary
benefit of low interest rates is their stimulative effect on economic activity. By reducing
interest rates, the Fed can help spur business
spending on capital goods—which also helps
the economy’s long-term performance—and
can help spur household expenditures on
homes or consumer durables like automobiles. For example, home sales are generally
higher when mortgage rates are 5 percent
than when they are 10 percent.
A second benefit of low interest rates is
improving bank balance sheets and banks’
capacity to lend. During the financial crisis,
many banks, particularly some of the largest
banks, were found to have too little capital,
which limited their ability to make loans during the initial stages of the recovery.
By keeping short-term interest rates
low, the Fed helps recapitalize the banking
continued on Page 2

T h e f e d e r a l r e s e r v e b a n k o f s t. l o u i s : C e n t r a l t o A m e r i c a’ s e c o n o m y ®

Low Interest Rates
continued from Page 1

rate of
return

system by helping to raise the industry’s net interest
margin (NIM), which boosts its retained earnings
and, thus, its capital. Between the fourth quarter
of 2008, when the FOMC reduced its federal funds
target rate to virtually zero, and the first quarter of
2010, the NIM increased by 21 percent, its highest

high low

Currency capital goods

Interest
mortgage

$

Credit

inflation

rate

Fed
Funds

investors

deflation

rate

yield

level in more than seven years. Yet, the amount
of commercial and industrial loans on bank
balance sheets declined by nearly 25 percent from
its peak in October 2008 to June 2010. This suggests
that perhaps other factors were working to restrain
bank lending.
A third benefit of low interest rates is that they
can raise asset prices. When the Fed increases the
money supply, the public finds itself with more
money balances than it wants to hold. In response,
people use these excess balances to increase their
purchases of goods and services and of assets like
houses or corporate equities. Increased demand for
these assets, all else equal, raises their price.
The lowering of interest rates to raise asset prices
can be a double-edged sword. On the one hand,
higher asset prices increase the wealth of households
(which can boost spending) and lower the cost of
financing capital purchases for business. On the
other hand, low interest rates encourage borrowing
and higher debt levels.

www.stlouisfed.org/education_resources

2

Costs of Low Interest Rates
Just as there are benefits, there are costs associated with keeping interest rates below the natural
level for an extended period. Some argue that the
extended period of low interest rates (below the
natural rate) from June 2003 to June 2004 was a key
contributor to the housing boom and the marked
increase in household debt relative to after-tax
incomes. Without a strong commitment to control
inflation over the long run, the risk of higher inflation is one potential cost of the Fed’s keeping the
real federal funds rate below the economy’s natural
interest rate. For example, some point to the 1970s,
when the Fed did not raise interest rates fast enough
or high enough to prevent what became known as
the Great Inflation.
Other costs are associated with very low interest rates. First, low interest rates provide a powerful
incentive to spend rather than save. In the short term,
this may not matter much, but over a longer period,
low interest rates penalize savers and those who rely
heavily on interest income. Since peaking at $1.33
trillion in the third quarter of 2008, personal interest
income has declined by $128 billion, or 9.6 percent.
A second cost of very low interest rates flows from
the first. In a world of very low real returns, individuals and investors begin to seek higher-yielding assets.
Since the FOMC moved to a near-zero federal funds
target rate, yields on 10-year Treasury securities have
fallen, on net, to less than 3 percent, while money
market rates have fallen below 1 percent. Of course,
existing bondholders have seen significant capital
appreciation over this period. However, those desiring higher nominal rates might instead be tempted to
seek more speculative, higher-yielding investments.
In 2003-04, many investors, facing similar choices,
chose to invest heavily in subprime mortgage-backed
securities since they were perceived at the time to
offer relatively high risk-adjusted returns. When economic resources finance more-speculative activities,
the risk of a financial crisis increases—particularly if
excess amounts of leverage are used in the process.
In this vein, some economists believe that banks and
other financial institutions tend to take greater risks
when rates are maintained at very low levels for a
lengthy period. Economists have identified a few
other costs associated with very low interest rates.
First, if short-term interest rates are low relative to
long-term rates, banks and other financial institutions
may overinvest in long-term assets, such as Treasury
securities. If interest rates rise unexpectedly, the
value of those assets will fall (bond prices and yields

move in opposite directions), exposing banks to substantial losses.
Second, low short-term interest rates reduce the profitability of
money market funds, which are key providers of short-term credit
for many large firms. (An example is the commercial paper market.) From early January 2009 to early August 2010, total assets of
money market mutual funds declined from a little more than $3.9
trillion to about $2.8 trillion.
Finally, St. Louis Fed President James Bullard has argued that
the Fed’s promise to keep interest rates low for an “extended

period” may lead to a Japanese-style deflationary economy. This
might occur in the event of a shock that pushes inflation down to
extremely low levels—maybe below zero. With the Fed unable to
lower rates below zero, actual and expected deflation might persist, which, all else equal, would increase the real cost of servicing
debt (that is, incomes fall relative to debt).
Kevin Kliesen is an economist at the Federal Reserve Bank of St. Louis.

Glossary

Interest income – The income received for allowing a financial
institution or another person to use your money.

Asset – Anything an individual or business owns that has commercial or exchange value.

Interest rate – The price of using credit expressed as a percentage of the amount owed.

Board of Governors – Central governmental agency of the
Federal Reserve System located in Washington, D.C., and
composed of seven members appointed by the president and
confirmed by the Senate.

Investment – The purchase of new capital resources; the diversion of resources from the production of goods and services
for current consumption to the production of goods and
services that increase the economy’s productive capacity.

Borrowing – Receiving something on loan with the promise or
understanding of returning it or its equivalent.

Loans – Money provided temporarily on the condition that the
amount borrowed, will be repaid, usually with interest.

Capital goods – Manufactured goods—such as machines, equipment, and structures—that are used to produce other goods
and services.

Market economy – An economy that allocates resources
through the decentralized decisions of many firms and households as they interact in markets for goods and services.

Deflation – A general downward movement of prices for goods
and services in an economy.

Monetary policy – A central bank’s actions involving the
use of interest rate or money supply tools to achieve
economic goals.

Federal funds rate – The interest rate charged by a bank on an
overnight loan of funds to another bank.

Net interest margin (NIM) – The difference between the
interest expense a bank pays (cost of funds) and the interest
income a bank receives on the loans it makes.

Federal Open Market Committee (FOMC) – A Committee
created by law that consists of the seven members of the
Board of Governors; the president of the Federal Reserve Bank
of New York; and, on a rotating basis, the presidents of four
other Reserve Banks. Nonvoting Reserve Bank presidents also
participate in Committee deliberations and discussion.

Rate of return – Also called the “yield,” this is the return on an
investment expressed as a percentage of its price.
Recession – A period of declining real income and rising unemployment; significant decline in general economic activity
extending over a period of time.

Federal Reserve System (FED) – The central bank of the
United States.

Risk – Exposure to loss of investment capital due to a variety
of causes, such as business failure, stock market volatility,
and interest rate changes; in business, the likelihood of
loss or reduced profit; the danger or probability of loss to
an individual.

Incentives – Perceived benefits that encourage certain
behaviors.
Inflation – A general, sustained upward movement of prices for
goods and services in an economy.
Inflation rate – The percentage change in the price index from
a previous period.

Unemployment rate – The percentage of the labor force that
is willing and able to work, is not currently employed, and is
actively seeking employment.

Interest – The price of using credit—that is, someone else’s
money—to make purchases.

Yield – The return on an investment, stated as a percentage of
the price. Also called rate of return.

3

www.stlouisfed.org/education_resources

w h a t ’ s y o u r question ?

Inflation and Deflation
Q. The Fed’s policymaking body, the Federal Open
Market Committee, usually targets the federal
funds interest rate to conduct monetary policy. In
response to economic conditions, the FOMC acted
to reduce that interest rate to near zero in December 2008. Did the Federal Reserve substantially
lower the rate in previous recessions?
A. Yes. In the graph of the federal funds rate (below),
the shaded bars represent recent U.S. recessions.
In these recessions, the federal funds rate dropped
as a result of the Fed’s policy actions. However,
the past recession was the only one where the rate
approached zero.

20.0

Percent of Change

17.5
15.0

Food and beverages
Housing
Apparel
Transportation
Medical care
Recreation
Education and communication
Other goods and services

12.5
10.0
7.5
5.0
2.5
1950

Q. What specific goods and services are
represented in the CPI’s market basket of
consumer goods?
A. The CPI is often referred to as the “all items
index.” Although it does not include literally all items,
it includes a representative selection of consumer
goods and services. Items are divided into more than
200 categories, arranged into eight major groups:

Effective Federal Funds Rate (FEDFUNDS)

Source: Board of Governors of the Federal Reserve System

0.0

items until the price was as low as possible. Delayed
spending results in fewer sales and less revenue
for businesses, which in turn reduces the need for
employees and thereby increases unemployment.
Another factor to consider is the cost of credit during deflationary times. Since the value of money
increases in a deflationary environment (each dollar
will buy more goods and services), debtors must
repay their old loans with more-valuable dollars, to
the benefit of their creditors.

1960

1970

Shaded areas indicate U.S. recessions

1980

1990

2000

2010

2020

2011 research.stlouisfed.org

Q. How is the inflation rate measured?
A. Although the level of inflation can be measured in
several ways, one of the most widely used measurements is the consumer price index (CPI). This index
is a monthly measure of the average change over
time in the prices paid by urban consumers for a
“market basket” (80,000 items) of consumer goods
and services. This urban consumer group represents
about 87% of the total U.S. population.
Q. Downward movement in the prices of goods
and services (lower prices) sounds good. So why
is deflation considered a problem?
A. Deflation can have undesirable “snowball” effects
on an economy. Although it may sound good, a general decreasing trend in prices discourages spending
and investment because consumers delay purchases
while waiting for prices to drop further. For example,
if the price of electronics, such as computers, tablets,
and the latest phones, consistently dropped every
week, you would probably delay purchasing these

www.stlouisfed.org/education_resources

4

Q. What is the core CPI?
A. The core CPI is the CPI excluding food and energy.
It may seem puzzling to exclude two categories of
great importance to all consumers, but here’s why it’s
done. Food and energy prices tend to be more volatile and subject to more price variation—sharp and
often short-term movements can obscure longerterm and underlying trends in other categories. For
example, gasoline prices can change several cents
per gallon overnight. By excluding food and energy,
the core CPI indicates the short-run inflation trend
without the risk of volatile prices concealing the true
picture of that trend.
Sources:
Hoda El-Ghazaly. “Deflation: Who Let the Air Out?” Federal
Reserve Bank of St. Louis Liber8, February 2011;
http://liber8.stlouisfed.org/newsletter/2011/201102.pdf.
Kevin L. Kliesen. “Is the Fed’s Definition of Price Stability Evolving?”
Federal Reserve Bank of St. Louis Economic Synopses, Number 33, 2010;
http://research.stlouisfed.org/publications/es/10/ES1033.pdf.
U.S. Bureau of Labor Statistics. “All Items Less Food and Energy.” Focus
on Prices and Spending: Consumer Price Index, February 2011, 1(15); http://
www.bls.gov/opub/focus/volume1_number15/cpi_1_15.htm#chart2.

e c o n o m i c snapshot

CPI and Core CPI

The two measures of inflation represented are the CPI
and the core CPI.

2.

What does each graph measure differently as
shown on the x-axis of each graph?
Each graph includes data for a different date range:
Graph A shows one year of data, Graph B shows ten
years of data, and Graph C shows more than sixty
years of data.

3.

Which one of the three graphs reflects a
smaller variation between the CPI and the
core CPI? Why?
Graph C shows a similar trend between both measures,
while Graphs A and B show greater differences and variances. This is because Graph C looks at the long-term
trend, and while the differences in the measurements on
the first two graphs appear substantial, over the long run
the trends for both the CPI and the core CPI are quite
similar. Graphs showing longer time spans will reflect
the long-run picture, whereas those with shortened time
spans will reflect short-term trends.

4. Which graph would be best for finding the
following types of information?
1.
The number of recessions over the past 50 years
2. The trend in inflation over the first quarter of 2010
3. The period with the all-time high inflation rate
4.	Speculating on the price levels of food and/or
energy in early 2011
5. Identifying recessions in the past 10 years

Fourth Quarter 2010
Q1-’10

Q2-’10

Q3-’10

Q4-’10

Growth Rate
Real Gross Domestic Product

3.7%

1.7%

2.6%

2.8%*

Inflation Rate
Consumer Price Index

1.3%

-0.5%

1.4%

2.6%

Civilian Unemployment Rate

9.7%

9.6%

9.6%

9.6%

* second estimate

Bureau of Economic Analysis: www.bea.gov.

Graph A
Consumer Price Index for All Urban Consumers: All Items (CPIAUCSL)
Consumer Price Index for All Urban Consumers: All Items Less Food & Energy (CPILFESL)
0.5
0.4
Percent of Change

What two measures of inflation are
represented in Graph A, Graph B, and
Graph C below?

0.3
0.2
-0.1

CPIAUCSL

-0.0

CPILFESL

-0.1
-0.2
-0.3
2010-01

2010-04

2010-07

2010-10

2011-01

2011 research.stlouisfed.org

Graph B
Consumer Price Index for All Urban Consumers: All Items (CPIAUCSL)
Consumer Price Index for All Urban Consumers: All Items Less Food & Energy (CPILFESL)
4
3
Percent of Change

1.

2

CPIAUCSL

1

CPILFESL

0

-1

2001

Source: www.bls.gov/cps/cps_htgm.hlm#nilf

2002

2003

2004

2005

2006

2007

2008

2009

2010

2011

2011 research.stlouisfed.org

Shaded areas indicate U.S. recessions

Graph C
Consumer Price Index for All Urban Consumers: All Items (CPIAUCSL)
Consumer Price Index for All Urban Consumers: All Items Less Food & Energy (CPILFESL)
15.0

Percent of Change

12.5
10.0
7.5

CPIAUCSL

5.0

CPILFESL

2.5
0.0

Answers: 1.-C; 2.-A; 3.-C; 4.-A; 5.-B and C;

-2.5

5

1940

1950

1960

1970
1980
1990
Shaded areas indicate U.S. recessions

2000

2010

2020

2011 research.stlouisfed.org

www.stlouisfed.org/education_resources

bulletin b o a r d

a l l l ocatio n s

memphi s

For more information on any of the following events, go to
http://stlouisfed.org/education_resources/events/ unless
otherwise indicated.

Third National Economic Education
Video Competition
April 18 deadline
For more information: http://stlouisfed.org/education_
resources/videocontest.cfm

A Webinar: Fiscal and Monetary Policy
April 20, 3:30 - 4:30 CST

Economics and Children’s Literature K-4
July 7, 8:30 - 3:30 CST

Insights from the Inside

Contact: Jeannette.n.bennett@stls.frb.org

Personal Finance Two-Day Workshop
for Tennessee Educators
Location: Agricenter International, Memphis, TN
June 1-2, 2011

Focus on the Economy
http://www.mscee.org/focus_signup.php
Jackson, MS
June 1-3, 2011

Dollars and Sense in the Classroom
Ittabama Community College
Tupelo, MS
June 15, 2011

July 14, 8:30 - 3:30 CST

Integrating Economics in the
Mississippi Classroom

Economics and Children’s Literature 5-8

Ittabama Community College
Tupelo, MS
June 22, 2011

July 21, 8:30 - 3:30 CST

It’s Your Paycheck!
s t. l o u i s

July 26, 8:30 - 3:30 CST

Contact: Barbara.flowers@stls.frb.org

Cards, Cars and Currency

AP Economics Program

July 27, 8:30 - 3:30 CST

June 16 and 17, 8:30 - 3:30 CST

Time Value of Money / It’s Your
Paycheck!
July 28, 8:30 - 3:30 CST

www.stlouisfed.org/education_resources

6

bulletin b o a r d

Bank Contacts
Little Rock
Pam Haynie
501-324-8205

AP Economics Program

Louisville
Caryn Rossiter
502-568-9257
Memphis
Jeannette Bennett
901-579-4104

8:30 a.m. - 3:30 p.m. | Thursday, June 16, 2011
8:30 a.m. - 3:30 p.m. | Friday, June 17, 2011 - Conference registration includes both days.

St. Louis
Mary Suiter
314-444-4662

Are you a seasoned AP economics instructor? Have you thought about teaching AP economics? Is your school or district interested in adding AP economics
courses to its curricula?

Barb Flowers
314-444-8421

If the answer to any of these questions is yes, please join us for a two-day workshop at the Federal Reserve Bank of St. Louis. Federal Reserve staff and experienced AP instructors will demonstrate engaging economics lessons and introduce interactive whiteboard applications developed
specifically for AP classes in micro and macro.

Scott Wolla
314-444-8624

The workshop will include whole-group discussions of best practices, course development, and
textbook selection. An “Ask the Expert” panel will delve into those thorny content problems,
offering ideas for alternative instructional approaches.
Participants receive:

•
•
•

12 hours of professional development
certificates of completion
continental breakfast and lunch both days

The workshop is free, but registration is required. To register, visit:
www.stlouisfed.org/education_resources/events/?id=229
For additional information, contact Barbara Flowers at barbara.flowers@stls.frb.org.

7

www.stlouisfed.org/education_resources

prsrt std
U.S. POSTAGE
PAID
ST. LOUIS, MO
PERMIT NO. 444

Inside the Vault is written
by economic education staff
at the Federal Reserve Bank
of St. Louis, P.O. Box 442,
St. Louis, Mo., 63166.
The views expressed are
those of the authors and are
not necessarily those of the
Federal Reserve Bank of
St. Louis or the Federal
Reserve System.

printed on recycled paper using 30% post-consumer waste

f e a t u r e d resources

The Economic Lowdown
The Economic Lowdown is a podcast series for high school
students produced by the Economic Education department
of the St. Louis Fed. The series covers topics in economics,
personal finance, banking, and monetary policy.
Currently, there are seven episodes available: Opportunity
Cost, Factors of Production, The Role of Self-Interest and
Competition in a Market Economy, Inflation, Unemployment,

Demand, and Supply. Market Equilibrium will be added this
spring, with more episodes to follow.
Everyone needs to hear things more than once—and
review is always helpful. So if your students need some
reinforcement of concepts you’ve taught, they can download
and listen to economic content on the bus, in the car, or
walking to class on exam day.

The Economic Lowdown is available on the Federal Reserve Bank of St. Louis’s website,

www.stlouisfed.org/education_resources/podcasts
and on iTunes.

www.stlouisfed.org/education_resources
©Shutterstock ultimax