With the economic recovery still lagging, the intended rewards of the Federal Reserve's aggressive campaign to lower interest rates have yet to be realized. But the cost of that campaign to depositors can be counted, and according to the latest MoneyRates.com analysis, it may have exceeded $200 billion in the last year alone.

That number brings the estimated three-year loss of purchasing power to U.S. depositors to more than half a trillion dollars -- a figure that demands a fresh look at the Fed's continued insistence on low interest rates.

Calculating the costs

Any attempt to quantify the overall cost of low deposit interest rates on a nation can only be a broad estimate. Still, when dealing with extremely large numbers -- which is the case when talking about the amount of money on deposit in U.S. banks -- this type of estimate can help get a handle on the overall cost of the Fed's extreme low-interest-rate stance.

The premise of MoneyRates.com's analysis is to hold the Fed responsible for the extent to which U.S. deposits have lost ground to inflation. Historically, short-term interest rates have generally been able to keep pace with inflation, but this has not been the case in recent years. Given that the Fed has gone to extraordinary lengths to keep interest rates down, this analysis holds them accountable for the amount by which interest rates trail inflation.

MoneyRates.com created its estimate in three steps:

  1. The starting point is the total amount on deposit in U.S. banks. According to the latest FDIC figure, this amount is more than $8.2 trillion.
  2. The next step was to calculate the amount of interest earned on those deposits over the past year. To estimate this, MoneyRates.com used average money market rates from the FDIC, since money market rates typically fall somewhere between average savings account rates and most CD rates.
  3. The final step was to adjust this by the amount of inflation over the past year, according to Consumer Price Index figures from the Bureau of Labor Statistics.

Based on this analysis, the purchasing power of U.S. deposits declined by $205 billion for the year ending March 31, 2012. When added to the estimated loss in purchasing power of $170 billion for the prior 12 months, and the $140 billion for the year before that, the estimated three-year cost stands at $515 billion and counting.

The policy debate

To be fair, the Fed has an answer for this.

In a speech posted on the Federal Reserve web site, Fed Board of Governors member Sarah Bloom Raskin suggested that critics of Fed policy should consider how American households have benefited from low interest rates. For example, anyone who took out or refinanced a loan in the past few years has been able to do so more cheaply because of the Fed's policy. Also, stocks, business equity and real estate are generally thought to benefit from low interest rates, so households that own those assets should benefit as well.

Certainly, low interest rates have helped some segments of the economy. They've also been a boon to borrowers and banks. However, those benefits are far from universal. For example, not everyone has been in a position to take out a loan, especially in a time of tighter credit standards and depressed real estate values.

As for the value low interest rates may have added to stocks, business equity and real estate, this would come in the form of asset values, but the impact of low interest rates reduces income. Because of its liquidity, income is likely to have a more immediate impact on the economy than asset values.

An unequal burden

The long-term test of the Fed's policy will be whether it succeeds in bringing down unemployment and enabling a recovery strong enough to allow the U.S. to address its budget deficit. This will be the final judgement of whether the stimulative benefit of low interest rates exceeded the damage of pulling a substantial amount of interest income out of the economy.

In the meantime, the Fed should acknowledge that even if the policy is successful, its burden is falling unequally. People with large portions of their assets in deposit accounts are subsidizing this stimulus, effectively handing money to banks and borrowers in the process.

The original article can be found at Money-Rates.com:
The high cost of the Fed's low rates