He is right about respecting objective economic reality.
.............................................................................................
brookings
Interest rates around the world, both short-term and long-term, are
exceptionally low these days. The U.S. government can borrow for ten
years at a rate of about 1.9 percent, and for thirty years at about 2.5
percent. Rates in other industrial countries are even lower: For
example, the yield on ten-year government bonds is now around 0.2
percent in Germany, 0.3 percent in Japan, and 1.6 percent in the United
Kingdom. In Switzerland, the ten-year yield is currently slightly
negative, meaning that lenders must pay the Swiss government to hold
their money! The interest rates paid by businesses and households are
relatively higher, primarily because of credit risk, but are still very
low on an historical basis.
Low interest rates are not a short-term aberration, but part of a
long-term trend. As the figure below shows, ten-year government bond
yields in the United States were relatively low in the 1960s, rose to a
peak above 15 percent in 1981, and have been declining ever since. That
pattern is partly explained by the rise and fall of inflation, also
shown in the figure. All else equal, investors demand higher yields when
inflation is high to compensate them for the declining purchasing power
of the dollars with which they expect to be repaid. But yields on
inflation-protected bonds are also very low today; the real or
inflation-adjusted return on lending to the U.S. government for five
years is currently about minus 0.1 percent.
Why are interest rates so low? Will they remain low? What are the implications for the economy of low interest rates?
If you asked the person in the street, “Why are interest rates so
low?”, he or she would likely answer that the Fed is keeping them low.
That’s true only in a very narrow sense. The Fed does, of course, set
the benchmark nominal short-term interest rate. The Fed’s policies are
also the primary determinant of inflation and inflation expectations
over the longer term, and inflation trends affect interest rates, as the
figure above shows. But what matters most for the economy is the real,
or inflation-adjusted, interest rate (the market, or nominal, interest
rate minus the inflation rate). The real interest rate is most relevant
for capital investment decisions, for example. The Fed’s ability to
affect real rates of return, especially longer-term real rates, is
transitory and limited. Except in the short run, real interest rates are
determined by a wide range of economic factors, including prospects for
economic growth—not by the Fed.
To understand why this is so, it helps to introduce the concept of the equilibrium real interest rate
(sometimes called the Wicksellian interest rate, after the
late-nineteenth- and early twentieth-century Swedish economist Knut
Wicksell). The equilibrium interest rate is the real interest rate
consistent with full employment of labor and capital resources, perhaps
after some period of adjustment. Many factors affect the equilibrium
rate, which can and does change over time. In a rapidly growing, dynamic
economy, we would expect the equilibrium interest rate to be high, all
else equal, reflecting the high prospective return on capital
investments. In a slowly growing or recessionary economy, the
equilibrium real rate is likely to be low, since investment
opportunities are limited and relatively unprofitable. Government
spending and taxation policies also affect the equilibrium real rate:
Large deficits will tend to increase the equilibrium real rate (again,
all else equal), because government borrowing diverts savings away from
private investment.
If the Fed wants to see full employment of capital and labor
resources (which, of course, it does), then its task amounts to using
its influence over market interest rates to push those rates toward
levels consistent with the equilibrium rate, or—more realistically—its
best estimate of the equilibrium rate, which is not directly observable.
If the Fed were to try to keep market rates persistently too high,
relative to the equilibrium rate, the economy would slow (perhaps
falling into recession), because capital investments (and other
long-lived purchases, like consumer durables) are unattractive when the
cost of borrowing set by the Fed exceeds the potential return on those
investments. Similarly, if the Fed were to push market rates too low,
below the levels consistent with the equilibrium rate, the economy would
eventually overheat, leading to inflation—also an unsustainable and
undesirable situation. The bottom line is that the state of the economy,
not the Fed, ultimately determines the real rate of return attainable
by savers and investors. The Fed influences market rates but not in an
unconstrained way; if it seeks a healthy economy, then it must try to
push market rates toward levels consistent with the underlying
equilibrium rate.
This sounds very textbook-y, but failure to understand this point has
led to some confused critiques of Fed policy. When I was chairman, more
than one legislator accused me and my colleagues on the Fed’s
policy-setting Federal Open Market Committee of “throwing seniors under
the bus” (to use the words of one senator) by keeping interest rates
low. The legislators were concerned about retirees living off their
savings and able to obtain only very low rates of return on those
savings.
I was concerned about those seniors as well. But if the goal was for
retirees to enjoy sustainably higher real returns, then the Fed’s
raising interest rates prematurely would have been exactly the wrong
thing to do. In the weak (but recovering) economy of the past few years,
all indications are that the equilibrium real interest rate has been
exceptionally low, probably negative. A premature increase in interest
rates engineered by the Fed would therefore have likely led after a
short time to an economic slowdown and, consequently, lower returns on
capital investments. The slowing economy in turn would have forced the
Fed to capitulate and reduce market interest rates again. This is hardly
a hypothetical scenario: In recent years, several major central banks
have prematurely raised interest rates, only to be forced by a worsening
economy to backpedal and retract the increases. Ultimately, the best
way to improve the returns attainable by savers was to do what the Fed
actually did: keep rates low (closer to the low equilibrium rate), so
that the economy could recover and more quickly reach the point of
producing healthier investment returns.
A similarly confused criticism often heard is that the Fed is somehow
distorting financial markets and investment decisions by keeping
interest rates “artificially low.” Contrary to what sometimes seems to
be alleged, the Fed cannot somehow withdraw and leave interest rates to
be determined by “the markets.” The Fed’s actions determine the money
supply and thus short-term interest rates; it has no choice but to set
the short-term interest rate somewhere. So where should that
be? The best strategy for the Fed I can think of is to set rates at a
level consistent with the healthy operation of the economy over the
medium term, that is, at the (today, low) equilibrium rate. There is
absolutely nothing artificial about that! Of course, it’s legitimate to
argue about where the equilibrium rate actually is at a given time, a
debate that Fed policymakers engage in at their every meeting. But that
doesn’t seem to be the source of the criticism.
The state of the economy, not the Fed, is the ultimate determinant of
the sustainable level of real returns. This helps explain why real
interest rates are low throughout the industrialized world, not just in
the United States. What features of the economic landscape are the
ultimate sources of today’s low real rates? I’ll tackle that in later
posts.
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