By Holden Smith & Skyler Ramirez-Ortiz
As of the 23rd of February, the US's interest rate, the "so-called federal funds rate" (Blanchard, 2017, pg 7), was 0.08%. There are many theories as to why this is happening and what it might mean for the future economy. But before that, I think it's imperative to know what low-interest rates do. As we all know, interest rates for you and I are what we have to pay back on any loan we take. It's the percent an investor will make taking you on as a gamble (investing in you). So typically, "Central banks often change their target interest rates in response to economic activity: raising rates when the economy is overly strong, and lowering rates when the economy is sluggish'' (Investopedia, 2020). Because this also has a direct effect on money supply, it also affects inflation. This all being essential Monetary Policy Central banks implement. We have been at around an interest rate of .1% for the last decade. The text refers to this as "zero lower bound" (Blanchard, 2017, pg7). An important concept is that "interest rates cannot be negative... Everybody would want to hold cash... because cash pays a zero interest rate" (Blanchard, 2017, pg7). So why is this so important, you might ask. Well, it means the federal reserve is stuck. They can't lower interest rates any further. In the words of the text, "Low-interest rates limit the ability of the Fed to respond to further negative shocks... if demand further decreases there is little the Fed can do to increase Demand" (Blanchard, 2017, pg8). The very opposite of what lowering the federal funds rate is intended to do. Now that we have an idea why this could be harmful, let's look at real-world data. The graph below shows the federal reserve’s actions to lower interest rates because of a want to heat up the economy post DotCom bubble. It is strongly believed that this cut in interest rates helped the economy recover. With the CPI slowly increasing due to running the economy hot, the Federal Reserve raised interest rates. The hope being that they would lower inflation, this didn't seem to work. Inflation was unaffected by the increase in interest rates. That and the 2008 recessions caused us to jump straight to the bottom where we sit now.
Now the exciting part: why is all of this happening? In the all-knowing words of Ben Bernanke, "Low-interest rates are not a short-term aberration, but part of a long-term trend" (Brookings, 2015). The downward trend has not been unnoticed, and many economists have even predicted that we might get stuck in this zero-bound interest rate. Regardless of predictions, the big question is still why? One journal I found quite compelling for this explanation is "a change in demographic" (IMF Economic Review, 2016, pg.636) Manly, the shifting of the Baby Boomer generation to retirement. Baby boomers being a "high-saving" (IMF Economic Review, 2016, pg.636) demographic. Where higher interest rates can be used as an incentive to save money, a generation that already does this needs little incentive. This leading to " inequality, whereby a rise in the share of income or wealth accruing to the high-saving rich has raised aggregate saving" (IMF Economic Review, 2016, pg.636). The saving distribution has widened due to the increase of Baby Boomers entering retirement/older age. However, what we would expect from this is " a rise in investment in the industrialized world. But in contrast ... nominal investment rates have fallen sharply across the industrialized world" (IMF Economic Review, 2016, pg.636). How they describe, this is "If the price of capital goods falls, a given quantity of savings can buy more capital goods, raising the return on investment for a given marginal physical product of capital. But the increase in the volume of capital goods lowers the marginal product, thereby lowering the return on investment ... a fall in the relative price of capital can lead to a fall in both the interest rate and investment rates." (IMF Economic Review, 2016, pg.636). Simply as you have more capital, it becomes less beneficial to invest, so why invest at all? This explanation has merit but is only one of the many that exist. This journal goes over another as well " house prices and household debt-to-income ratios rose to historic highs before the crisis across the industrialized world" (IMF Economic Review, 2016, pg.636). The rise of debt, both public and private, has dramatically increased over the years. The fear that increased spending would lead to higher inflation just doesn't seem to be the case in most industrial countries—higher inflation leading the Fed to set a higher interest rate to slow down the economy. We would typically see as public debt rises a crowding-out effect. "That means the government—because it is the most creditworthy borrower—sucks up capital and leaves less available to private borrowers. They must then pay more for it via higher interest rates or a weakened currency." (Forbes, 2019). This just doesn't seem to be happening in the US and other advanced economies, like Germany. The reason why this isn't happening at least from this one article, is that "we have crossed a kind of debt Rubicon in recent history. In much of the developed world, the existing debt load is so heavy that additional dollars have a smaller effect. The new debt’s negative effects outweigh any benefit." (Forbes, 2019) The graph below shows how the percent of debt compared to GDP has grown since 2005, reaching around 100% in 2013. Spending more is no longer dramatically increasing inflation, leading to interest rates having less of an effect on the economy. The third and final reason this might be happening is from the text. The US might be stuck in a "liquidity trap" (Blanchard, 2017, pg80). Meaning: "once people hold enough money for transaction purposes, they are indifferent between holding the rest of their financial wealth in the form of money or in the form of bond" (Blanchard, 2017, pg7). Once individuals’ money supply becomes this large, unless money demand (nominal income) increases, we won't see an increase in interest rates. A liquidity trap is predicted to happen mostly when interest rates are already low and saving is relatively high. And right now, we see an increased amount of saving, from stated earlier, Baby Boomers.
All of these factors seem to play heavily into each other. To me, it looks like we are in the perfect storm, high savings due to long built-in ideals, low demand for investment, increasing public and private debt—all of these factors building and each other cause us to be stuck at zero bond interest. I can say that the pandemic-induced recession is not going to help this problem, only exacerbate it. I, in all honesty, don't know what is going to happen. As of right now, the Fed chair, J. Powell, has said, "When the time comes to raise interest rates, we’ll certainly do that, and that time, by the way, is no time soon." I don't expect to see an increase in interest rates anytime soon; we are still in the midst of a recession, and slowing down the economy even before the fiscal stimulus impacts seem foolish. With the spike in debt relative to GDP in 2020, it doesn't look like we will see a slow down in that either. Many of the trends I looked over seem to be continuing. We indeed are in an interesting time and at the forefront of whatever the hell is happening. This can be summed as: take out loans and not bonds; it’s what most governments want us to do anyway.
Works Cited
Bernanke, B. S. (2016, July 29). Why are interest rates so low? Brookings. https://www.brookings.edu/blog/ben-bernanke/2015/03/30/why-are-interest-rates-so-low/
Mauldin, J. (2019, May 29). This is Why Monetary Policy Is So Ineffective. Forbes. https://www.forbes.com/sites/johnmauldin/2019/05/29/this-is-why-monetary-policy-is-so-ineffective/?sh=64c3a0f16182
Sajedi, R., & Thwaites, G. (2016). Why Are Real Interest Rates So Low? The Role of the Relative Price of Investment Goods. IMF Economic Review, 64(4), 635–659. https://doi.org/10.1057/s41308-016-0016-y
Seabury, C. (2020, December 17). How Interest Rates Affect the U.S. Markets. Investopedia. https://www.investopedia.com/articles/stocks/09/how-interest-rates-affect-markets.asp
US Inflation Calculator. (2021, February 10). Current US Inflation Rates: 2000-2021 |US Inflation Calculator. https://www.usinflationcalculator.com/inflation/current-inflation-rates/
Board of Governors of the Federal Reserve System (US). [FEDFUNDS]
FRED Federal Reserve Bank of St. Louis.
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