Unemployment is high, and projected to remain high for the foreseeable future. The output gap (the gap between the potential capacity of the economy to produce and its actual production) is assumed to be high because of the large number of unemployed. As a result, inflation is low, and inflation expectations are also low. Credit growth is very muted. By almost every metric, it would seem there are no costs to keeping interest rates near zero for the foreseeable future, especially if the government’s ability to infuse additional useful fiscal stimulus is waning.
Indeed, those who worry about incipient deflation argue that even zero nominal rates may produce high real rates. They would prefer negative nominal rates (you pay someone money to lend to them), if that were at all possible. Despite these seemingly compelling arguments, I will argue in what follows that the benefits of ultra-low interest rates may be overstated and the costs understated.
1) One benefit of low short term interest rates is that it pushes down long term interest rates and encourages firms to invest. What is unclear is how much additional investment we forego by pushing rates up from zero to low, but non-zero, levels. I would wager it is not huge. Large corporations today are not worried about their cost of capital in funding projects, they are worried about revenues, and about whether they should invest in the U.S. or move operations abroad. Small corporations are worried about access to funding, not about its cost. This is not to say that raising interest rates a little, and with adequate warning, to get them back up to 2 or 2.5 percent will have no effect on corporate investment. My conjecture, however, is that if the market is well prepared, the adverse effects on investment and sentiment will be small.
2) Another benefit of low rates is that they might prop up asset prices, especially the price of housing. But if rates are unnaturally low, are we preventing prices from reaching their natural level, and thus holding back the necessary adjustment that the housing market has to make?
3) Ultra-low interest rates are, undoubtedly, a tax on savers, especially risk averse ones. It tells them to (a) bear the pain while seeing the returns on their deposit and money market accounts dwindle to nothing, or (b) take more risks to eke out extra returns, or (c) to go out and spend. Given the state of household balance sheets, the latter two actions seem unwise. If households are unwilling to be pushed to spend, the net effect of ultra-low interest rates will be to reduce household incomes (because they get no interest) and further reduce household demand. It will also push them to take more risk.
In other words, some commentators seem to think that ultra-low interest rates are a boon from the Fed to the economy, without any costs to anyone. But there are costs. The costs are paid by households who forego interest income, and the benefits are especially reaped by those who borrow short term. Who might these be?
4) The most obvious beneficiaries are banks. Ultra-low interest rates are a direct subsidy to banks, who make enormous profits by lending at the higher long term interest rate (augmented by fat credit spreads) while they pay savers a pittance. The boost to bank profits through this subsidy dwarfs the size of TARP. Clearly, the Fed hopes that by recapitalizing the banks through the backdoor, they will have an incentive to lend more. But what if instead they pay out the profits as dividends and bonuses because lending opportunities are bleak? And what if these dividends and bonuses go to richer households whose propensity to spend is small, while the burden of low interest falls most directly on poorer households (who are more likely to have the bulk of their savings in bank deposits) whose propensity to spend is large? Could ultra-low interest rates actually dampen demand? It is not out of the realm of possibility.
My sense is that we do not know enough about the effect of ultra-low interest rates to state categorically that they are an unmitigated good for reviving the economy. But perhaps the most important cost of low rates is its effect on risk taking and illiquidity seeking. Remember that the United States Fed under Greenspan helped precipitate the recent crisis by keeping rates too low too long. That suggests we cannot be sanguine about the risks that are being taken now. Indeed, many of those who urged Greenspan to keep rates ultra low then are urging the Fed to keep rates ultra low now.
5) A growing number of studies that suggest that banks (and other financial institutions) tend to take more risk, both on the asset side and through leverage, when interest rates are kept low for a long time. Clearly, banks search for yield when rates are low. I have papers with Doug Diamond that suggest that if rates are expected to be low for a sustained period (and the Fed intervenes to provide liquidity whenever the market tightens), banks also take on a lot of liquidity risk by borrowing short term and investing in illiquid assets. Yes, none of this risk taking and illiquidity seeking seems excessive just now, especially because the European crisis has put a dampener on exuberant markets, and because banks are still nursing their past wounds. But we must remember that there was talk that covenant lite loans were back in vogue before the European problem hit us. Once the anxiety about Europe dies down, covenant lite loans, and worse, will be back. Also, we must remember that risk taking did not seem excessive in the run up to the crisis, until we learnt the banks had gone overboard.
6) The greatest damage is done when the Fed assures the economy that it will stay on hold for a sustained period. Such assurances provide incentives for financial institutions to stretch even more for risk. Indeed, given that bank balance sheets become loaded with risk, it becomes even harder for the Fed to raise rates when more traditional indicators like inflation suggest the need to do so. Ultra-low rates not only become addictive, they also make the Fed a prisoner of the expectations it sets.
There are two more reasons to consider raising rates from the ultra-low to the low.
7) By expropriating responsible savers in favor of irresponsible banks, the Fed teaches banks that if they collectively get the system into trouble, the Fed will respond with ultra-low interest rates for an indefinite period, until even the most badly-managed surviving bank recovers. It is hard to imagine that all the regulations being contemplated will offset the gigantic moral hazard that Fed policy is engendering. Few in authority seem to worry about moral hazard today – after all, why worry about the next crisis when we are still dealing with the current one. But it is precisely now that we will create the expectations that will drive the financial sector in the future.
8) Clearly the Fed’s stated mandate is domestic employment and price stability. But its narrow focus has global implications. Until the European crisis precipitated a flight to quality, money fleeing low US interest rates (and more generally, industrial countries) pushed up emerging market equity and real estate prices. Emerging market policy makers have been caught in a bind. If they raise domestic interest rates, they attract more capital, see their currency appreciate, and lose competitiveness. This would not be all bad if they were sure the capital would stay in. But the past experience with inflows has been that much of it will leave when industrial countries start raising rates, putting enormous pressure on emerging market finances, often precipitating crises. If emerging market central bankers leave interest rates low, they risk setting off not just domestic asset price bubbles but also high inflation; even if corporations in the United States are not hiring, corporations elsewhere are. Emerging economies around the world are on the brink of overheating; Brazil’s unemployment rate, for example, is at lows it has not seen for decades, while wages for even unskilled labor in China are growing at a rapid clip.
If the Federal Reserve were to accept the responsibilities of its role as central banker to much of the world, it would have to admit that its policy rates are too accommodative for the world as a whole. Does the Fed have responsibility to help the world while hurting its own economy (or as one commentator put it, am I advocating that the U.S. raise rates because Brazil is overheating)? Of course not! But when the benefits to its own economy are dubious, it should also give some thought to the global effects of its policies. For eventually, the consequences of its policies will come back to haunt it if they precipitate crises elsewhere.
Hopefully I have convinced some of you that the case for sustained ultra-low rates is not as airtight as some make it to be. With sustained ultra-low rates, we risk restarting the cycle of debt fueled consumption and excessive leverage that brought us to grief just recently. At any rate, I do believe it is legitimate to start the debate about when and how the Fed will bring rates back to a low and still accommodative level, and up from the ultra-low level set in response to the panic. And that decision cannot be driven solely by inflation and unemployment numbers. I am glad the Chairman Bernanke seems to be hinting at starting the dialogue.