The Efficacy of the FOMC’s Zero Interest Rate Policy
Here’s a good essay from the St. Louis Fed, examining how effective ‘permanent zero’ rates are. As you know, I think permanent zero is toxic. Let’s see what the St. Louis Fed is saying though.
Since the late 1980s the Federal Open Market Committee (FOMC) has conducted monetary policy primarily by setting a target for the nominal overnight federal funds rate. In late 2008 the FOMC set the target at zero. It has since indicated that it expects the target to remain at zero until late 2014. Should this happen, the funds rate will have been zero for nearly six years. This essay suggests the possibility that the net effect of such a prolonged zero interest rate policy might be harmful for economic growth.
The so-called interest rate channel of policy works by adjusting the real rate of interest relative to what it would be if the FOMC did not increase or decrease its target for the funds rate. Reducing the funds rate target reduces real longer-term rates, which provides an incentive for businesses to increase capital investment, but only to the extent that the policy action reduces longer-term real rates.
The reduction in the real rate also affects consumer spending through what economists call income and substitution effects. The lower interest rate increases the price of future consumption, causing inpiduals to increase current consumption and reduce current saving—the substitution effect. The lower rate also reduces current interest income, which induces inpiduals to save more and consume less—the income effect. Consequently, consumption can increase or decrease depending on the relative magnitudes of the income and substitution effects.
That’s exactly what I have been telling you. When looking at GDP growth (from a flow perspective only), the question is whether the lower rate gooses credit growth enough to overcome the negative effects of lower interest income. What I have been saying is that credit growth effects don’t overcome lost interest income in a balance sheet recession. Just the opposite happens. Moreover, the stock variable effects of easy monetary policy in terms of increases in debt as a percentage of income or GDP have been quite negative over the past quarter century, as two economists from Deutsche Bank have recently detailed.
What about the indirect effects of permanent zero?
Persistently lower real rates can have an indirect effect on consumption because they induce individuals to take on riskier investments. Standard portfolio theory sees investors as balancing the risk of holding a particular set of assets against the average portfolio return. The desired portfolio is one that minimizes the risk for a given average return. Reducing the real rate of interest on bonds (especially low-risk bonds) relative to all other investments induces investors to hold riskier portfolios to increase the average return. Hence, in addition to the direct effect on current income, persistently low real interest rates might motivate individuals to save more in an attempt to compensate for lower expected future returns and higher risk. This effect is likely to intensify the longer real rates are abnormally low.
Two thing here: first, there is the savings effect that the St. Louis Fed has identified. Ultra easy monetary policy may induce savers to save more and therefore reduce consumption. That’s the perverse, even deflationary effect of easy money in a balance sheet recession. But then there are the distributional effects of altering private portfolio preferences. Investors are geared toward “riskier investments”. Translation: easy money creates malinvestment. When the Fed engages in financial repression to artificially suppress the price signal that interest rates represent, capital goes to riskier enterprises and projects. And when the risk-on trade turns to risk-off in recession, the losses are enormous. That’s what we saw during the TMT bubble in the late 1990s and what we saw again last decade with the housing bubble.
Bottom line: ultra-easy monetary policy has unintended consequences. Not only does it reallocate resources toward riskier investments, in a balance sheet recession, easy money may also induce savers to reduce consumption in order to increase savings, accelerating the very credit and demand deflation it is seeking to reverse.
When the Federal Reserve extends its zero rate policy to 2015 later this week, this essay is something to remember, especially if recession comes to the US despite the Fed’s efforts. It is during recession that the toxic effects of ultra-easy monetary policy are most clearly manifest.