From ZIRP to NIRP Part II: The Effect of Low Interest Rates on the US Recovery

The Fed’s Monetary Policies in the Post-Recession Era

At the height of the recession in December 2008, the US Federal Reserve adopted historically low interest rates, slashing the federal-funds rate from 1% to between zero and a quarter percentage point. Like the Bank of Japan, the Fed sought to catalyze economic activity and combat deflation by reducing the cost of borrowing for households, businesses, and banks.

A month earlier, it had also started an aggressive quantitative easing program to inject additional liquidity into the economy, buying back bonds and mortgage-backed securities, and adding more than $3.5 trillion to the Fed balance sheet by 2014. Though its easing program tapered off by October 2014, Fed chair Janet Yellen announced that the central bank would reinvest proceeds from the bonds, in effect, providing another stimulus.

The Tepid Global Economic Recovery

Despite these unconventional monetary policies, America’s economic recovery has been tepid and largely unresponsive. According to Yale economist Stephen Roach, “Real GDP growth in the US has averaged only 2.1% in the 28 quarters since the Great Recession ended in the third quarter of 2009 – barely half the 4% average pace in comparable periods of earlier upturns.”

At the outset, the effects of the near-zero interest rate were partially stifled by already high levels of household and business debt, as well as the fact that prospective borrowers with even the slightest level of risk faced high interest rates. And in 2016, with the Fed maintaining historically low interest rates, there is little reason to suggest that a lack of liquidity and credit is ailing creditworthy households and businesses.

The Downsides of Negative Interest Rates

Even so, the persisting concerns about the health of the global economy and the volatility of the financial system have spurred calls for negative interest rates, to be implemented by charging banks for reserve deposits. While this ought to in theory create a similar stimulus effect to the 2008 interest rate cuts, the benefits of such a policy would be limited by the fact that there is a floor on nominal interest rates, in that depositors can always hold onto their cash. The potential downsides to a drastic policy include tarnishing the credibility of the Fed and heightened uncertainty. Moreover, lowering interest rates from their already low levels would constrain the Fed’s ability to vary its monetary policy in the event of a Japanese-style deflationary trend, and force it to turn to even more unconventional policies such as QE.

Persistently low interest rates also encourage excessive risk-taking and higher leverage, posing risks to financial stability. Those seeking higher nominal interest rates are encouraged to turn to more speculative assets. Low interest rates generally incentivize spending and penalize saving, reducing household interest incomes. The St. Louis Fed notes that “Since peaking at $1.33 trillion in the third quarter of 2008, personal interest income has declined by $128 billion, or 9.6 percent.” Some also argue that low interest rates led to the mid-2000s housing boom and a significant spike in household debt.

While a strengthening economic recovery and declining unemployment (down from 10% in October 2009 to 4.9% currently) may prima facie support the view that the Fed’s unconventional monetary policies are working, Roach notes that weak output and the productivity downturn raise worrying questions about the long-term, especially in the context of frothy asset markets.

An emerging consensus holds that the global economy’s current woes are beyond the abilities of creative monetary policy and financial engineering to remedy, and that they may be exacerbated by excessive risk-taking. As such, Notre Dame economist Eric Sims counsels focusing on structural issues such as demographic pressures, declining productivity, and disruptions born of globalization that have hampered economic growth.

References:

http://www.wsj.com/articles/SB122945283457211111

https://www.bloomberg.com/quicktake/federal-reserve-quantitative-easing-tape

http://www.cnbc.com/2016/02/10/the-danger-of-negative-interest-rates-commentary.html

https://www.stlouisfed.org/publications/inside-the-vault/spring-2011/low-interest-rates-have-benefits-and-costs

http://voxeu.org/sites/default/files/file/Geneva17_28sept.pdf

https://www.project-syndicate.org/print/desperate-central-bankers-by-stephen-s–roach-2016-09

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