Learning to Live With the Fed's Low Rates
The Federal Reserve last week decided not to hike interest rates just yet. This seems like a sensible enough decision -- labor market indicators are looking a bit weak, inflation is still a little below the Fed's 2 percent target, and Brexit and China’s slowdown are obvious macroeconomic risks. Why raise rates when economic conditions look a little subpar?
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People have come up with a lot of reasons to worry about zero interest rates. At first they worried about inflation, and later about financial instability and bubbles caused by a reach for yield. But the years passed, and there was no inflation, no bubble or instability in financial markets. So people are finding new reasons to be afraid of low rates. Unfortunately, as the fears have failed to pan out, the new worries are getting pretty vague.
A good example is a recent column in the Washington Post by Steven Pearlstein, which echoes criticisms made by many other skeptics of low rates. Declaring that the Fed isn’t raising rates fast enough, Pearlstein offers the following argument:
The reason is best explained by analogy: Monetary stimulus has long since accomplished its Keynesian purpose of stabilizing a very sick patient and putting her on the path to recovery. But at this point, there’s been so much of it, and it’s gone on for so long, that the full range of the economy’s natural healing processes have been prevented from kicking in…
Administering more medicine is actually harmful because the patient is now addicted to it. It’s time to begin the withdrawal process even as we take other steps to reduce the painful side effects.
Pearlstein relies on this medicine analogy several times in his article. But to my knowledge, there is little support for his “addiction” idea in the economics literature. No mainstream economic theory says that businesses get habituated to low rates. No empirical study I’ve ever heard of reveals such an effect. If this is a real phenomenon, it’s one that Pearlstein has discovered well before the economics community.
The closest thing I can think of is the research showing that people’s early life experiences affect their expectations -- for example, people born during a big inflation tend to expect inflation to be higher than it actually is. By analogy, if we keep rates at zero for a generation -- as Japan has done -- we might get some businesspeople who are astonished if and when rates are finally raised. That’s somewhat similar to what Pearlstein is postulating, but I feel like I’m really going out on a limb to find research that supports his analogy.
Pearlstein’s other worries seem equally vague. He states that low rates have “badly distorted the price of financial assets relative to the price of everything else.” I’m skeptical of this -- low rates raise the fundamental value of financial assets by lowering discount rates, which is perfectly natural and not a distortion. But even if Pearlstein is right, and prices are distorted, how much should we care? Stocks and bonds are not consumer goods -- we don’t need them to live. The only reason we should worry if their price goes up is that it might suddenly come crashing down. And so far, despite years of warnings about Fed-generated bubbles, no crash has materialized. That’s also true for Japan, which has had zero rates for a quarter-century now without any financial instability. Of course, no one can predict with confidence that a crash won’t come tomorrow, but there is so far no evidence that a low-rate policy increases risk.
So why is Pearlstein -- like so many others in the business community and the media -- worried about low rates? My hypothesis is that people are simply uncomfortable with low interest rates because they feel weird. This is the first time in history that we’ve had zero rates for this long. A return to higher rates feels like a return to normality; Pearlstein, like many others, even uses the word “normal” when referring to rates above zero. Fed officials frequently use this term as well.
But it isn't clear that history is a good guide to what policies we should regard as normal. Just because rates were usually above zero in the past doesn’t mean that the Fed’s current policy is extraordinary. The Fed’s job isn't to keep interest rates at a historically average level, but to support full employment while keeping inflation at about 2 percent. With inflation a bit less less than that and unemployment of less than 5 percent, the Fed’s policy targets look very normal indeed. Why should the Fed try a risky policy move -- and raising rates is definitely risky -- to try to fix something that doesn’t look broken in the first place?
So maybe it’s time we learned to live with low interest rates. Maybe what feels weird now will start to feel normal in a decade or so. Low rates might be hurting our economy in subtle ways that are currently impossible to detect -- Pearlstein’s “addiction” analogy might be right -- but I don’t think we should just assume it’s right, and change policy based on that assumption.
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