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Scott Burns uExpress.com Web

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04/03/2001

THE INCOME EFFECT

Allow me to introduce the Income Effect. It is identified very simply. When people have rising incomes, they spend more. When people have declining incomes, they spend less.

Yes, you might say "duh" to that. But you never know who might be reading.

The same thing that most of us would say is painfully obvious could also require a dozen doctorates, a room full of high-speed computers, the best regression analysis money can buy, and a $250,000 government grant, renewable for 10 years.

Although it lacks the drama of the better known "wealth effect" -- the tendency of consumer spending to rise when people feel richer and to fall when people feel poorer -- the Income Effect will be having an impact on our economy in coming months.

The first impact will be relatively dramatic: pink slips representing a 100 percent loss of income.

The second impact will also be deep, but more subtle -- the loss of spending power now rolling toward anyone who invests for interest income. The income loss, as I estimate it, will be around 25 percent for Treasury investors. For CD investors the decline will be somewhat less, about 15 percent.

Why so much less for CD investors?

Because they started with lower yields than Treasury investors received. Typically, bank certificates of deposit have provided somewhat lower yields than Treasury obligations with the same maturity. In recent weeks, reductions in interest rates coming from the Federal Reserve have dropped Treasury yields so fast they now yield somewhat less than comparable CDs. (Readers who would like to see the long-term history of CD vs. Treasury yields can see it on my Web site at www.scottburns.com/wwbanker.htm.)

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With a sinking economy and public expectations that the Federal Reserve will reduce interest rates still further, the Income Effect is likely to get worse, not better.

So let's measure it.

Five years ago, a five-year Treasury would have provided you with a yield of 5.97 percent. When it matures, you will be looking at a replacement yield of 4.46 percent. That's a decline of 151 basis points.

It's also 25 percent less cash to go into your checking account each year.

This drop applies across the board, from three-month T-bills on up, witness the table below. Anyone who depends on interest income has a major adjustment coming. Unlike lost fortunes in stock options -- money that gets spent on things like Porsches, Viking Ranges and other objects of luxury lust -- the people who count on this money will be reconsidering their eating habits, canceling vacations in their state and substituting trips to Blockbuster for nights at the movies.