This month the American economy has been expanding for 121 months straight, the longest expansion on record. Despite this interest rates are low, and monetary policy is a powerful tool for policymakers to use to stimulate the economy and fight recessions. I’ve written before about how I believe that low rates are the new normal but today I want to take a historical perspective and compare how low today’s rates really are, and discuss the potential implications both in terms of policymaking and in terms of how it affects the average American’s wallet.
After compiling the data on what the Federal Reserve (Fed)’s federal funds rate have been between 1971 and 2018 I’ve averaged the numbers to find the decade average interest rates. Here are the results:
As the data clearly shows, rates have been falling since the peak in the 80’s which leads to less room to manoeuvre in terms of rate decreases. To me, it seems that if the trend continues and rates continue to stay low then the Fed has put itself in a so-called liquidity trap. The liquidity trap is a Keynesian concept where a central bank has lowered interests enough that diminishing returns to rate decreases have essentially rendered monetary policy ineffective, at least conventional monetary policy. This brings me to my next point, if the Fed is in a liquidity trap where conventional monetary policy is ineffective then it has two options, one is to raise rates to give itself some more room to manoeuvre, and the other is to use unconventional policy such as negative interest rates or quantitative easing. The problem with raising rates is that it’s a contractionary policy which could slow the economy or even trigger a recession which makes it difficult to get out of the liquidity trap and leaves unconventional policy the more likely option. I personally dislike quantitative easing as I believe it has a regressive wealth distribution profile, I won’t go into the details here but if you’re interested you can read a previous post about why here.
Let’s shift away from policymakers and discuss how this affects the average American. Low interest rates mean cheaper borrowing which former Fed chairman Ben Bernanke has argued benefits low income households as they tend to have more debts than high income households. This is true but I think the more important effect is that long bouts of low interest rates can exacerbate inequality. Bernanke is correct in that low rates benefit borrowers but what he doesn’t consider is that there are different types of borrowers. Low interest rates help those who have borrowed to consume spend less on interest payments which is good, but it benefits those who use low interest rates to leverage their investments far more. The point here is that while low interest rates is good for all borrowers, it it’s bad for all savers who save in a bank account and it seems likely to me that it benefits the wealth far more than the rest.
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Written by Karl Johansson, Founder of Ipoleco
Cover photo by Pixabay on Pexels
Source for historical data on interest rates: https://www.thebalance.com/fed-funds-rate-history-highs-lows-3306135
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