Sometimes Maggie Smith worries that she may outlive her savings.

It's an uncomfortable feeling to realize that everything is going up except your income, said the 74-year-old from Galloway, New Jersey.

Rising home and car insurance costs have forced her to dip into savings which have been earning less than 1.0 percent.

That isn't likely to change for some years.

The Federal Reserve said on Wednesday that it is likely to keep its key interest rate near zero until late 2014. That would make more than five years of rock-bottom rates.

For Smith and other pensioners struggling to cope with inflation higher than the rate of interest they earn on their savings, all of this amounts to, as she puts it, being punished for being prudent.

She is a casualty of the Fed's strategy to keep rates low in an attempt to generate the economic growth needed to lower the nation's jobless rate. Low borrowing costs also prevent the U.S. federal government's debt burden from getting even further out of control.

The same could be said for the policies of central banks in other developed nations, including the European Union.


The low rates policies are being pursued in preference to raising taxes and making even steeper cuts in spending, which would be unpopular and would cause more damage to already fragile economies.

The authorities are also giving favorable treatment to some forms of government debt as part of bank capital requirements, as an encouragement to banks to hold it.

There are also signs of more tax policies geared to keeping money in a particular country. Some even foresee overt capital controls being introduced to prevent people and companies from investing money offshore.

On taxes, President Barack Obama's proposal in his State of the Union address on Tuesday to use tax policy to penalize companies who move jobs and profits offshore and favor those who create them in the U.S. might be seen as part of the trend.

In economic policy circles, holding interest rates below inflation to ease debt levels and limiting capital mobility is known as financial repression, and it can go on for years, even decades.

This is not something you choose to do because it's a great idea, said Carmen Reinhart, an economist and senior fellow at the Peterson Institute for International Economics. It's something you do out of necessity.

Indebted governments around the world held down rates in the decades after World War II, eroding the value of their obligations, until the 1980s.

With many industrialized economies again up to their necks in debt, governments are going beyond tools already employed, such as central bank purchases of debt.

Repression has been more explicit in Europe. Greece, for example, has kept down its short term borrowing rates by excluding bills and European Central Bank holdings from debt that will take a loss in its debt restructuring.

But U.S. and international banking regulatory reform also favors holding government debt over other debt - which lets the government borrow money at a lower cost than would be expected.


Though controversial, financial repression has an impressive track record.

Between 1945 and 1980, when inflation was higher than benchmark interest rates, the United States and Britain cut their debt on average by more than 3.0 percent annually, Reinhart's research showed.

If you have negative rates for 10 years, that's a 30 percent debt reduction -- nothing to scoff at, she said, noting that rapid growth helped this process as well.

That punishes savers, however, who see the value of the debt they purchased eroded by inflation.

RBS bond analyst William O'Donnell compares the Fed's current low-rate regime with U.S. interest rate caps used from 1942-51, aimed at lowering borrowing costs for a country at war.

It could be another four years before another rate rise, he said. Rate repression can last longer than people have patience for.

That's starting to sink in on Wall Street.

In mid-2011, yields on benchmark 10-year U.S. Treasury notes kept falling even as economic data improved, breaking a correlation that persisted even during the crisis of 2008.

That was partly tied to fears of Europe's debt crisis, but analysts also credit the sense that the Fed would hold rates low for longer than previously expected and perhaps even resort to another round of bond purchases to lower mortgage rates.

That runs counter to the normal state of bond market affairs in which signs of stronger growth coincide with higher yields. That's because investors normally anticipate inflation and sell Treasuries in favor of other assets that promise better returns.


GRAPHICS: U.S. debt under financial repression: Government yields vs. Citigroup economic surprise index: Distribution of EFSF bond purchases:



But giving savers a rough deal to help governments cope with their fiscal distress could have long-term consequences as more and more Americans and Europeans reach retirement age unable to generate the income needed to sustain their spending.

Around 55 million people in the United States were aged between 50 and 64 in 2008, a crucial age for savers, compared to 41 million a decade ago, according to the U.S. Census Bureau.

Japan is aging at an even faster pace, as the government statistics bureau predicts nearly 40 percent of the population will be over 65 in 2050, up from 23 percent in 2010.

For the past two decades, Japanese households scarred by the bursting of a property bubble have been all too happy to buy relatively safe government debt despite rock-bottom rates.

As they retire, Japan's pensioners may not earn enough to sustain spending. If those buyers look elsewhere, it would force up rates on Japan's debt load, which is more than 200 percent of total output.

For financial repression to work in the U.S., the Fed must also maintain what Tad Rivelle, chief investment officer at TCW, one of the largest U.S. bond funds, called a pool of fools.

Somebody has to be willing to keep their money in a Treasury note yielding 25 basis points for this to work, to effect the transfer, Rivelle told Reuters last month.

That's an easier sell for the United States simply because of the dollar's dominant role in world trade.

Without it, the U.S. Treasury would almost certainly have to pay more than 2.0 percent to borrow money for 10 years, especially now that marketable U.S. debt is now more than $10 trillion, some 70 percent of the country's total annual economic output.

As long as inflation does not spiral into double digits, analysts say Washington should be able to keep on offering miserly returns to holders of U.S. government debt.

Investors waiting for a great eruption of inflation are a bit like the proverbial frog being slowly boiled alive without knowing it, said Russell Napier, a strategist at Hong Kong-based brokerage CLSA Asia Pacific.

It's not going to be hyperinflation, default or depreciation, he said. It's going to be forcing savings into the government bond market. It's happening every day but the market is kind of ignoring it. But the theft is underway.


Efforts to hold down rates in Europe may be more extensive. Talk in financial markets has it that European governments are already leaning on their banks and pension funds to buy up more sovereign debt to help lower governments' borrowing costs.

When the European rescue fund set up to tide over indebted governments sold three-year bonds this month, results showed European bidders snapped up 76 percent, with banks buying up 62 percent, according to IFR Markets, a unit of Thomson Reuters.

The extensive wreckage left by the financial crisis has some in the markets fearing governments may turn to outright capital controls to keep money at home to reduce their own borrowing costs. These could include taxes or other policies that would encourage companies to repatriate overseas funds or prevent money from leaking into more lucrative assets abroad.

If Europe's crisis worsens, Napier said authorities may be tempted to resort to more explicit controls to keep money from flowing to higher-returning assets abroad.

I would be very surprised if we get through 2012 without some form of capital controls in the euro zone, he said.

There are some signs things are pointing in this direction.

Ireland's government said last year it would tax private pensions to finance a job creation initiative.

The Bank of England in December published research that built a case for capital controls, including taxing foreign borrowing in some cases, noting economies performed better in the decades after World War II, when capital mobility was low.

That's still a remote scenario for the United States. But if foreign central bank demand for Treasuries fades, it could boost pressure on domestic buyers, including households, banks and pension funds, to buy more bonds, Reinhart said.

Already, she noted that new global and U.S. capital standards and regulatory reforms encourage banks to hold government debt over other assets.

When we take a snapshot of markets at the end of this year, I think they will be a lot less liberal than they were in 2006, Reinhart said. And I don't think that ends in 2012.

(Reporting By Stephen C. Johnson and Karen Brettell; Editing by David Gaffen)