Is the World Overdoing Low Interest Rates?

Low interest rates are supposed to accelerate economic growth. But if central banks cut rates too much, they could actually slow the economy. So says a counterintuitive theory that's making the rounds in academic and banking circles.

“Fed actions may be having little effect, or even effects opposite to those the Fed intends,” Charles Calomiris, an economist at Columbia Business School, wrote in an article in the winter issue of the libertarian Cato Journal called “The Microeconomic Perils of Monetary Policy Experiments.”

The concept that central banks might inadvertently make matters worse starts from an uncontroversial principle: Banks make money on the difference—the margin—between how much they must pay to attract deposits and how much they can earn by lending them out. Problems arise when central banks lower interest rates toward zero or even below, because the banks’ profit margins get compressed. The rate that banks are able to earn on their loans is pushed down by the central bank's action. But they can’t lower how much they pay for deposits by an equal amount. That would require them to pay less than zero for deposits, which depositors won’t stand for. People would rather keep their cash under the mattress than pay to keep it in a bank.