What Are the Consequences of Long Spells of Low Interest Rates?
62nd Economic Conference
Some have argued that the Federal Reserve’s accommodative policy in the early-to-mid-2000s maintained interest rates that remained too low for too long a period, and thereby contributed to the financial imbalances that led to the 2007–2009 financial crisis. Specifically, this viewpoint contends that this extended episode of low interest rates encouraged financial imbalances to build, as reaching-for-yield behavior by investors led to a misallocation of resources and credit that distorted relative asset prices and encouraged excessive leverage by investors. In the wake of the financial crisis and the slow recovery from the Great Recession, we have experienced an even longer episode of accommodative monetary policy and even lower interest rates, including an extended period at the zero lower bound. Is this current phase the precursor for another financial crisis, or has the US economy evolved to a “new normal” state that is characterized by lower equilibrium nominal interest rates compared with the historic norm?
In other words, does the low interest rate environment of recent years reflect a phenomenon that is atypical but essentially cyclical, or an economy that has experienced a fundamental structural shift to a new environment that is characterized by slow productivity growth, persistently low inflation, and thus low nominal interest rates? These concerns are intensified by the unusual convergence of historically low interest rates across Europe, Japan, and the United States. The answer to whether these events are cyclical or structural raises important questions about whether this extended episode of low interest rates will, in fact, encourage the formation of new financial imbalances. If such imbalances are present, do the relatively low risk premiums observed across a wide range of assets indicate a reduction in perceived risk or a reduction in the compensation investors require to take on a given amount of risk?
Given that a key part of the transmission mechanism associated with an easing of monetary policy is to induce investors to take on more risk, when and how can this incentive become counterproductive, putting the economy’s performance at risk? What are the potential costs and risks associated with the Fed’s transition from an extended period of historically low interest rates to interest rates more consistent with a sustainable environment of full employment at our inflation target? In particular, what are the risks that such a transition will be associated with another financial crisis and/or a severe recession, due to either the bursting of an asset bubble or due to a sharp rise in interest rates that could bring down asset prices and stress highly leveraged investors, firms, and consumers? How severe would the economic disruption be if investors abruptly revised their perceptions of their risk exposure and/or their willingness to take on risk? In light of the unprecedented period of persistently low US interest rates, how might future monetary policy address both the initial buildup and the subsequent potential consequences of the financial imbalances that can emerge?