The Problem with Managing Interest Rates

The Fed Funds Rate has gone down for the past 35 years

The big economic news this month is what the Federal Reserve will do to short-term interest rates, the rate at which banks loan each other money overnight. Currently, the rate is close to zero, and has been since the height of the banking crisis in 2009.

The Federal Reserve manages short-term interest rates to regulate the economy and inflation. In a recession, when the employment rate falls, they’ll lower rates so that people will borrow and spend more. This will increase demand and stimulate the economy. If inflation gets too high (i.e. prices are increasing rapidly), they’ll raise rates, so that people borrow less. As a result, there will be less money to buy goods, reducing inflation and slowing the economy.

The Fed’s been at this for a while, and it’s mostly worked–inflation has been under control for decades and we were able to come out of the Great Recession and banking crisis. However, I think there are some big problems with this strategy.

The horrible incentives

Everybody loves it when the economy is roaring. Everyone has a job. Businesses are making piles of money and hiring more workers every day. Salaries are increasing. Politicians claim credit for the economy and get re-elected. Life is good for pretty well everyone.

And in a slowdown, life becomes pretty bad. People lose their jobs and their houses. Businesses profits decline as demand falls and corporations start to compete for what little demand remains, driving down prices. Politicians lose their jobs.

So, if you’re in charge of the interest rates, people will hate you when you raise rates and love you when you lower them. Now, Federal Reserve Bank Presidents, in theory, are supposed to be blind to these forces, and just act in the long-term good. But I think Federal Reserve Bank Presidents actually have a higher motivation: not to look like a nincompoop.

If you’re in charge of interest rates and the economy gets overheated, people won’t care too much. Everyone will be making more money! What’s not to love? On the other hand, if you raise rates too quickly, or set them too high, you can put the economy into a tailspin, creating your very own recession or depression. And, more importantly, you’ll look like a nincompoop.

So, I think that the Federal Reserve almost certainly has a “lower interest rate” bias. I think they’ll interpret the data in such a way to keep interest rates lower than they should be.

GDP not going up fast enough? Decrease interest rates.

Employment plateauing? Decrease interest rates.

House prices skyrocketing? Asset price inflation doesn’t count as inflation, so keep interest rates flat.

Escalating debt

But is that really a problem? Everyone loves a party, right?

The problem with keeping interest rates low for extended periods of time is escalating debt and the creation of asset bubbles. When rates are low, people borrow more. This fuels the economy and also bloats the prices of assets that can be purchased with debt. That’s one of the reasons why there was a housing bubble in the USA and currently is a housing bubble in Canada.

What’s more, when people see the Federal Reserve managing interest rates to bail out the economy, they begin to plan for this to happen. They think the economy is far less volatile than it is. They take on more risk believing that the Fed will “save them” by dropping rates dramatically if something goes wrong. And they’d largely be right.

The reckoning

But then what happens when rates go up? There’s two options.

The first option is that the asset prices collapse. A bunch of people default on their debt because they can’t afford to pay the debt at higher interest rates and the assets are no longer worth what they paid. So the economy is destroyed.

The second option is that the Fed sees the economy getting demolished by higher interest rates, so lowers interest rates even more to avoid a collapse. This does boost the economy, but it also leads to more debt, making it even harder to raise rates later.

So, by managing interest rates, you’re able to avoid a recession, but only by creating an economy that’s even more dependent on perpetually decreasing interest rates and the ratcheting up of debt levels.

The problem with that strategy though, is that you can’t decrease interest rates forever and can’t increase debt levels forever. After a certain point, people can’t take on more debt and lenders won’t lend to people who won’t pay them back (e.g. see Greece). And then you have an explosion.

Increasing fragility

So, by managing interest rates to avoid the short term pain of recession, you get to the point where a much larger blow-up is inevitable. In essence, managing interest rates decreases the medium-term volatility of the economy, but greatly increases its long-term fragility. The result is piles of debt, inflated asset prices, and an economy dependent on debt to achieve any growth.

Is there a better way to do things? I suspect there is, but I’m not sure what it is yet. And I’m confident that we won’t change the way of doing things until there is a massive blow-up. The problem is obvious now, but politically people won’t be willing to do anything about it (those incentives again), until there’s been at least one big blow up.

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