Are Low Interest Rates Bad for the Economy?

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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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