Why are Interest Rates so Low?

Higher Interest RatesWhy are interest rates so low?

Ask most people on the street why interest rates are so low, and they will reply that central banks are
responsible. Okay, perhaps most people have no idea about interest rates or central banks and would likely shrug their shoulders, but regular blog readers are certainly aware of all of the central bank actions to try to keep rates low!

However, academics and economists are increasingly opposing this commonly held notion, countering that interest rates are affected by more powerful market and economic forces than central banks, contending that the decline in productivity is causing rates to be low. Therefore, which theory is correct? The answer may be both – and linked to the same cause.

The ‘natural’ versus ‘market’ rate of interest

To understand what may be going on, we need to go back to the 19th century economist Knut Wicksell, who differentiated between the ‘natural’ rate of interest and the ‘market’ rate.

Interest rates are a type of pricing and, like prices, they signal the relative supply and demand for something; in this case, the supply and demand for loanable funds. The natural rate of interest is the equilibrium rate that balances the amount of money to be loaned and borrowed, or the level of savings and investment. This natural rate therefore coordinates economic activity much like prices coordinate activity.

Like other prices, the equilibrium or natural interest rate that correctly balances economic activity cannot be known by someone. Only the market process can bring it about, and it is constantly changing and adapting to different conditions.

The natural rate of interest is affected by real economic forces; people changing their preference for saving versus taking on debt, or consuming now versus later. But the market rate is the rate that is the prevailing interest rate, influenced by central bank actions as they target various rates to be lower.

Central banks claim they want to set the market rate at where they believe the natural rate to be, in order to bring about a balanced economy. But this is an impossible task. Just as no central planner knows the correct price of steel or milk, so the Federal Reserve does not know the correct interest rate to set in order to coordinate economic activity.

It is this very attempt at setting rates that causes so much economic upheaval. If the Federal Reserve sets rates too low (or too high), misallocation of resources will occur, typically in the form of inflation, bubbles and then subsequent crashes.

Is the Federal Reserve the perpetrator of low rates?

A main criticism to this theory is that interest rates have been low now for quite a long time, and therefore there is something else going on besides the Federal Reserve and other central banks keeping rates low.

In other words, such critics believe the natural rate of interest is actually very low and has been declining, therefore the Federal Reserve is merely setting market rates to be consistent with this low natural rate level.   

One of the reasons cited for the decline in the natural rate is the decline in productivity of American workers and the general sluggishness of the economy. However, this may actually be a symptom of the previous boom and bust caused by erroneous central bank actions, rather than an unrelated factor.

The Fed set rates too low

The Federal Reserve fueled the unsustainable boom prior to 2008, and we are still feeling the negative effects today, such as  lower productivity. Because the Fed set market rates below the natural rate, misallocation of resources occurred. Instead of allowing those resources to reallocate themselves to better uses (such as out of housing and banking), the Fed was intent on keeping the status quo and avoid liquidations and bankruptcies.

The Bank of International Settlements (BIS) suggested this possibility in their recent annual report, noting that low interest rates could actually cause a cycle of lower productivity:

“Alternatively, persistently low yields could end up having pernicious effects on the economy and become to some extent self-validating… They may also distort financial and real economic decisions more generally, for instance by encouraging unproductive firms to maintain capacity or by inflating asset prices, thereby weakening productivity.”

We see this when we examine so-called zombie banks that continue to hold bad loans on their books in order to avoid the charge-offs. We also see factories and retail stores that continue to operate because the Fed has incentivized consumers to continue to spend, rather than cut back on spending, repay debt and save.

Central banks should stop meddlingRate Hike Calculator Words Increased Interest Cost Borrow Money

In conclusion, there are certainly other factors and forces that determine interest rates, besides the central banks. But lower productivity may actually be a logical outcome of previous low rates set by central banks. This is precisely why central banks should get out of the business of trying to set the correct interest rate, just as Soviet central planners had no business trying to set the price of eggs.

What does this all mean for your investment portfolio? As long as central banks try to guess at what interest rates “should be”, they will fail. This will cause continued misallocation of resources, and therefore investors need to be aware of continued instability such as inflation, bubbles and crashes.

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