This commentary was written by Dr. Daniel Thornton of D.L. Thornton Economics.
Most economists agree that monetary policy actions to reduce interest rates can increase spending and, thereby, increase output. Monetary policy actions can help an economy recover from events that are due to a decline in spending. However, there is no agreement in the economics profession whether persistently low interest rates can make an economy that is growing slowly grow at a faster rate.
Nevertheless, since the financial crisis central banks have adopted persistently low interest rate policies (in some cases negative nominal interest rate policies) and purchased large amounts of securities in an attempt to stimulate the economies’ growth rate to its pre-financial-crisis level. Everywhere the result has been the same—economic growth slower than before.
Historically, economists have argued that monetary policy could not increase the economic growth rate because actions to reduce interest rates would increase the inflation rate frustrating the monetary authority’s ability to reduce nominal rates and, hence, real interest rates. But this hasn’t happened. Inflation in the U.S. and Europe has remained low in spite of the extremely aggressive policy actions of the European Central Bank (ECB) and the Fed. The new question is can central banks increase the economy’s long-run growth rate by keeping nominal and, hence, real rates low for an extended period of time?
One reason to doubt that it can is the fact that a country’s output depends on the quantity and quality of its labor and real capital and the efficiency with which these resources are used. Consequently, the growth rate of output depends on the growth rates of labor and capital and on innovations, of all types, that increase the productivity of labor and/or capital. Keeping the central bank’s policy rate low or negative and purchasing large quantities of government and other debt can’t directly affect any of these.
The indirect effect of low interest rates is also questionable. Economists have long been aware of the fact that lower interest rates have, at best, a modest effect on spending. Indeed, none other than Ben Bernanke noted this fact in a famous article co-authored with Mark Gertler in 1995 (here). The authors noted “empirical studies of supposedly ‘interest-sensitive’ components of aggregate spending have in fact had great difficulty in identifying a quantitatively important effect of the neoclassical cost-of-capital variable” (the real interest rate). Nothing has changed since 1995.
These research findings are not surprising. It is well known that the most important determinant of investment is the expected real rate of return on the investment. The threshold expected rate of return for making such investments is very high, about 15 percent. Hence, keeping the real rate low cannot stimulate investment spending in an environment where there is considerable uncertainty or where the expected return on investments is low. Reducing interest rates has an even more modest effect on consumer spending because such actions have a relatively small effect on most of the interest rates consumers pay.
Then there is the fact that persistently low interest rates reduce the real income of retirees and others with fixed nominal incomes. The negative effect on spend for such individual will at least partially offset the effect of lower interest rates on other’s spending. Perhaps even more important, low interest rates cause retirees, pension funds, and others to invest in more risky assets in the search for higher returns. The long-run consequence of such behavior for economic growth is uncertain and potentially harmful.
Negative nominal interest rates are particularly dangerous. It makes no sense to pay someone interest to borrow from you since you can get a zero nominal interest rate by just holding cash. Indeed, nominal interest rates could not be negative were it not for the fact that holding large amounts of currency is risky and costly. Recent attacks on currency, in particular large denomination currency, are motivated in large part by the desire to make interest rates more negative. The more costly currency is to hold, the more negative nominal interest rates will be.
Despite such concerns and the lack of agreement in the economic profession as to whether central banks’ interest rate policies can increase an economy’s long-run growth rate, the ECB and the Fed are on the brink of pursuing more aggressive low interest rate policies because economic growth is weak. Before they do, they should be required to do two things, neither of which threatens their independence. They need to explain why economic growth has remained weak in spite of the aggressive low interest rate policies they’ve already pursued and why they expect the outcome to be different this time.
This is a Hedgeye Guest Contributor piece written by Dr. Daniel Thornton. During his 33-year career at the St. Louis Fed, Thornton served as vice president and economic advisor. He currently runs D.L. Thornton Economics, an economic research consultancy. This piece does not necessarily reflect the opinion of Hedgeye.