The High Cost of Low Interest Rates
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The Fiscal Times
March 16, 2012

On Tuesday, the Federal Reserve announced that it would continue its policy of exceptionally low interest rates for at least another two years. It believes that this is a policy that will be most conducive to growth. However, some economists are starting to question this policy, viewing it as evidence of “financial repression” that may be hindering growth.

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Interest rates have fallen sharply over the last several years. In 2006, the prime rate charged by banks to their best customers was close to 8 percent and the rate on new mortgages was close to 7 percent. The AAA corporate bond rate was close to 6 percent and rates on risk-free Treasury securities were close to 5 percent. Lately, the prime rate has been 3.25 percent, the new mortgage rate has been a bit over 4 percent, the corporate bond rate has been just under 4 percent, and the rate on short-term Treasury securities is barely above zero.

A key reason for low interest rates is that the Fed has reduced the fed funds rate to between zero and 0.25 percent (one quarter of one percent). This is the rate that banks charge each other on overnight loans. Therefore, it is the basic cost of money to banks. In 2006, this rate was close to 5 percent. The Fed effectively controls the fed funds rate by being willing to create as much money as necessary to keep the rate in its target range.

In theory, a low fed funds rate should bring down the entire rate structure until financial markets begin to fear that an increase in the money supply has become inflationary. At that point, long-term interest rates will rise by approximately the expected inflation rate. Thus, if markets expect one percent higher inflation in the future, long-term rates will rise one percent so that lenders get the same real rate.

For this reason, economists view the term structure of interest rates—the ratio of short-term rates to long-term rates—as an accurate measure of expected inflation. This is particularly easy to calculate by looking at the market for Treasury inflation-protected securities (TIPS), which increase the principal on bonds by the consumer price index. Since the principal on regular Treasuries are not protected, comparing rates between the two classes of securities tells us exactly how much inflation markets expect at any moment in time.

Despite a sharp increase in the money supply, inflationary expectations have fallen, yet business investment and home buying have not picked up.

According to the Federal Reserve Bank of Cleveland, the TIPS market shows that inflationary expectations continue to be very low and falling. Financial markets are expecting just over one percent inflation for the next several years and less than 2 percent over the next 30 years.
 
In theory, low interest rates should stimulate growth because businesses will borrow to invest in new plant and equipment, and both businesses and consumers will refinance loans to free up cash flow and increase disposable income. And insofar as low interest rates reflect an easy money policy, they should raise inflationary expectations. If businesses know that they will be able to charge higher prices in the future, the prospect of increased profits should also stimulate investment. Families expecting higher home prices in the future should want to buy now and so on.

Bruce Bartlett’s columns focus on the intersection of politics and economics. The author of seven books, he worked in government for many years and was senior policy analyst in the Reagan White House.