The primary method that the Federal Reserve Board uses to help control the macro economy is by adjusting interest rates through setting the Federal Reserve discount rate. For the last 3 years or more this rate has been near zero – and the Fed has publically projected the continuation of low rates for another 2 years. These low rates have yet to result in the recovery of a “normal” economy. There are some possible negative consequences to holding this rate too low for too long. For example, the Greenspan Fed in the 2001-03 period held the rate very low for what some thought was too long and that it contributed to the housing related financial crises that began in 2007. So it might time to ask if this is still the right policy to follow.
Trying to control the economy with interest rates seems to me a little like trying to control a wagon from behind with a rope. If the wagon is going too fast, pulling on the rope is an effective way to slow it down, but if it is stopped, pushing on the rope will not get it started again. If the economy is going too fast – or “overheating” – interest rate increases can be an effective way to slow it down by making money for investment and other expenditures expensive. However, based on my years doing evaluation of investment opportunities for a major corporation, I think that below some level, interest rates make very little difference in investment decisions. There are other factors that become more important and are necessary before a decision to expand plant, equipment or jobs is made. How low is low enough? The answer is probably “that depends”, but my sense is that when the level gets below 2-3%, the rate becomes immaterial. If the other factors are not positive, the investment in plant and equipment that creates earnings and new jobs will not be there. Another difficulty the is that the rates the Fed has the most control over – short-term rates – are not likely the ones that have the most influence over investment decisions. The Fed obviously recognizes this and has take steps to bring down long-term rates with some success. Again the question is how low do those rates have to be to not be a deterrent to decisions to invest, and my sense is that we are currently below that point.
Modern economic theory incorporates the concept of “rational expectations”. It assumes that people – unlike machines or lesser animals – will consider many factors in assessing their future actions and will not necessarily therefore always react the same way to government attempts to stimulate the economy whether it be with interest rates or other monetary or fiscal actions. Therefore, both the context and the timing of these actions is important. In the 2007-2008 period when the current financial crisis started, I think reducing interest rates was the right thing for the Fed to do. People expected and wanted the government to take some action to cushion the fall which resulted from the downturn. But we have been flat at the bottom for some time now and people are looking for a return to a “normal” economy. Interest rates near zero are obviously not normal. Historically, real interest rates have run 2-3% above the inflation rate. So if the targeted inflation rate is 1-2%, normal interest rates should be in the 4-4.5% range. This would probably be considered a “neutral” range where rates would not be a drag on business investment in a “normal” economy. By holding rates abnormally low and projecting a continuation of that for 2 more years, the Fed is obviously signaling that they don’t expect a return to normal any time soon. If that’s the case and you are a business owner, why would you be in a hurry to expand?
Another negative consequence of the current low rates is that they hurt the income of both individuals and organizations. Particularly hurt are individuals who are retired or partially retired and are supplementing their retirement income with interest from savings accounts or CDs that have current near zero rates. And the longer it goes the worse it gets, since as CD’s and time deposits come due, it’s impossible to reinvest that money at comparable rates. Not only individuals, but also organizations with endowment funds are reducing their spending with low-interest rates because they are restricted to only spending interest and dividends from those funds and not the principle.
A long run of low-interest rates could distort other behaviors which could have negative longer term consequences as well. While it’s not likely we will have another housing bubble, there are indications that people are looking at other higher risk investments in order to maintain income. A headline in the Wall Street Journal of March 3rd reads “IRAs Get Sexier – Disillusioned With Returns on Conventional Investments IRA owners are Turning to … Other Alternatives”. Most of those mentioned have higher risks than “Conventional Investments”. One of the safest (conventional) investments historically has been U.S. Treasury bonds. The treasury bond yield curve reported in the same Wall Street Journal addition had the 10 year yield at less than 2%. With the currently projected government deficits for the next 10 years, it’s seems likely that the inflation rate will be 2% or higher with the result that there would be a loss in real dollar income from today’s investment in treasury bonds. So it is not surprising that there is some evidence that there is more money moving into “junk” bonds and other riskier investments. It would seem that the outcome of all all this “alternative” behavior will not be good.
So if low rates are not providing incentive for new investment and they are causing other negative or potentially negative actions, it may be time to do something different. If the government wants to get a “normal” economy, it is probably necessary for the people to act normally. And if they want the people to act normally, the government may need to start acting normally. The Fed’s current policy is certainly not normal. I’m not suggesting that move immediately to a “normal” interest rate immediately, but I think an immediate start in that direction would be good.