Are Low Interest Rates Bad for the Economy?

Earlier this week, the Federal Reserve had its regularly scheduled meeting and Bernanke & Co. decided to keep short-term interest rates at near zero, as they have been for a while. Low interest rates are supposed to spur growth by encourage borrowing, giving people more money to spend and invest. But interest rates have been really, really low for more than a year and the economy is still in the dumps, with unemployment remaining near 10%. That has Keith McCullough over at Henry Blodget’s blog The Business Insider questioning whether low interest rates themselves are part of the problem:

Our advice yesterday (for the US government to become Rigorously Frugal) was born out of the respect we have for both the cost and access to capital. Promising a “risk free” rate of return of ZERO percent to both domestic and foreign investors will not inspire investment. We live in an interconnected world where capital seeks yield. Ask the Brazilians and Chinese what they think about that..

I think McCollough is right that interest rates do have some signaling power. But not enough to break the laws of economics. Here’s why:

Here are the basics, which I think we can all agree on though I’m sure Roger MM will find some fault in my explanation. The Federal Reserve sets very short-term interest rates. Everything else gets set by bond investors. Lower interest rates generally make it easier to borrow money because it allows banks to borrow money at cheaper rates, and then lend it to others, again at cheaper rates. Companies and individuals would then invest that money in a expanding their business or perhaps their wasteline with a night out at a nice restaurant. Either way, someone is spending money.

What McCollough gets wrong is what type of investment we are talking about. Yes, low interest rates do not make US government bonds an attractive investment. That’s the point. In fact, with interest rates at historic lows you could argue Treasury bonds are too attractive already. What low interest rates do is make every other US investment more attractive, and get that money away from Treasuries. Raising Treasury rates would only draw money out of the private sector. Yes, you could investment elsewhere in the world, but there are still plenty of people who want to dollar-based investments.

So the question comes down to signaling. Does keeping US interest rates low scare people from investing in US companies and real estate? I don’t think so. Look at Apple. What I think is going here is that McCollough is mixing up the affects of interest rates and business cycles? It’s not low interest rates that are scaring people away from buying a house or a bigger one. It’s the fact that housing prices will fall or they will lose their job that is scaring people away from buying a house. The same is true for any investment these days. Low interest rates do signal that the US economy remains weak, but I think the economy is doing a fine job of telling people that all by itself.

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dotybj

He’s assuming the risk premium, i.e. the rate of return you get for a risky investment that is in excess to the risk free rate, is constant. It follows that a lower risk free rate would lead to a lower overall rate of return. So a country with a higher risk free rate would offer higher total returns.
http://rodgermmitchell.wordpress.com Rodger Malcolm Mitchell

If low rates stimulated, you might expect rates at the start of a recession to be considerably higher than the rates at the end of the previous recession.
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But, since 1971, there doesn’t seem to have been a consistent rule you could establish regarding interest rates at the end of a recession, vs. interest rates at the start of the next recession. See: INTEREST RATES.
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Greenspan and Bernanke had 20 rate decreases, that failed to save the economy. These decreases seemed to have no effect at all.
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Perhaps one reason might be that interest rates are neutral. That is, for every lender, there is a borrower. Low rates may benefit borrowers somewhat, but hurt lenders, including all us buyers of T-securities, CDs, money markets, savings accounts.
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Further, it is questionable that low interest rates even can have more than a very short term effect on the desire to borrow. Yes, you might buy a car or a home when rates are low, but will you really fail to buy when rates are high? Perhaps, but only briefly.
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For most businesses, interest is a minuscule part of total costs, and few businesses will fail to borrow for expansion, etc., just because rates are high.
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In total, I suggest interest rates are a much overblown part of the domestic economy, though they can have one important function: Fighting inflation.
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Rodger Malcolm Mitchell

(Stephen, sorry about fault-finding, but don’t you find it educational?)
geaugailluminati

irregardless of what low rates signal, the Fed must leave the rates low in order to recapitalize the banks, which are still insolvent…

http://marketwatch666.blogspot.com/2010/04/banks-insolvent-extend-and-pretend.html
http://rodgermmitchell.wordpress.com Rodger Malcolm Mitchell

Interesting thought. What is the mechanism by which low interest rates help to recapitalize banks?

Rodger Malcolm Mitchell
bacotawordpress

“It’s not low interest rates that are scaring people away from buying a house or a bigger one. It’s the fact that housing prices will fall or they will lose their job that is scaring people away from buying a house. ”

In other words (well speaking to the fear of housing prices falling) it is the fear of *deflation*. That is, that interest rates of zero are still too high.
ps56penn62pr64

Any banking system that creates money as the principal of loans will fail, regardless of the magnitude of the interest charged.

When money is created as the principal of loans, the loans must be repaid with interest. Repaying the loans destroys the money, all of the money the loans created.

If there, is no debt; there is no money. If there is no money, paying interest is impossible. If fulfilling the loan contracts is impossible, the system must fail.

Only by functioning as a classic Ponzi scheme does a reserve banking system appear to work for a short period, but they are unsustainable and inevitably crash.
highestandbest

The recap of banks is accomplished through influencing the spread between short and long term rates. By keeping short term rates ultra low the Fed has increased the spread and created more opportunities for easy profits for banks, who, of course, borrow short and lend long.
nativekentuckian

Sure, low interest rates will stimulate sales of home, cars and different products that for the most part need financing, at least temporarily,but let’s look at the primary reasons that banks are under capitalized. Americans are not saving money like we used to….I know that I will not put my money in a savings account that only pays 2% or less, ….that won’t even keep up with inflation…..and I am sure a lot of other folks feel the same way. Also, when interest rates are as low as they are right now, it takes away from the percieved value of our currency…..(Heck, if the Feds don’t think it’s worth anything, why should we?)
If interest rates were raised in increments that would stimulate savings first and foremost, the banks would have all the funds they need to make loans without the Federal Government and the taxpayer having to bail them out.
http://senekaross.wordpress.com senekaross

Low interest is the best way for new way establishment.
Low rates serve for progress in thinking.

http://japan-russia.jimdo.com/main/

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