What Low Interest Rates Hath Wrought

When the Federal Reserve Open Market Committee meets this week, they will discuss whether to raise interest rates for the first time in three years. President Trump, on the other hand, has made clear his preference for lower rates to reduce the deficit and help the economy grow out of its debt problem. This view is shared across the political spectrum as most policymakers believe lower rates are generally desirable and understand the tradeoff to be the risk of higher inflation. But it’s not true that lower rates are necessarily better for investment and growth; keeping rates too low for too long fuels financialization and reduces the productive capacity of the U.S. economy.

The conventional economic understanding of how interest rates influence the business cycle is incomplete at best. According to that narrative: The Federal Reserve sets short-term interest rates for the economy. When it wants to stimulate growth, it lowers interest rates. Conventional neo-Keynesian theory, on which the Fed’s economic models are based, argues that this effect occurs through the investment component of Gross Domestic Product (GDP). Lower interest rates mean a lower cost of capital for the private sector, which makes companies more likely to deploy capital productively. Their investment causes the economy to grow and the unemployment rate to fall. When the economy starts to run too “hot,” inflation rises. The Fed raises interest rates to make borrowing more expensive. Investment falls, growth slows, inflation comes down.

Or so the theory goes.

Yet over the past 25 years, non-residential investment has shown little correlation with interest rates. The Fed can set short-term rates, but investment cycles are driven primarily by other, more amorphous factors: animal spirits, technology, trade policy, regulation, and so on, all of which are outside the Fed’s purview.