The Downside of Low Interest Rates


In today’s commentary Stephen Roach takes on the subject of low real interest rates.  His argument is that by keeping real interest rates so low for so long (short term real rates have actually been negative for a couple of years now) in order to stimulate the economy, the Fed creates other problems.  These potential problems take the form “carry trades” – the practice of borrowing at low short term interest rates and then turning around and immediately lending the money out at higher long term interest rates – and asset price bubbles.  Both of these in turn entail their own set of risks to the economy.


So if these are indeed potential problems, what should the Fed do?  Well, it all depends on your priorities, or what you think the Fed’s objectives should be.  Should the Fed’s goal be to alleviate current unemployment?  Should they try to maximize long-run economic growth?  Should they worry only about the rate of inflation of consumer prices, or should they also worry about asset prices?  If the latter, how should they decide when rising asset prices change from being good to being bad?


There’s no right answer to these questions.  I would suggest that the goal of the current Board of Governors of the Fed is primarily to keep the inflation faced by consumers low while avoiding deflation, and then secondarily to improve the current employment situation, where that secondary goal doesn’t conflict with the primary goal.  But Roach is arguing,  in effect, that trying to boost current employment may in fact endanger long run economic growth, because the concomitant asset price bubbles that are allowed to grow in the process of boosting current employment cause economic problems down the road.  If that’s the case then the Fed is faced with an unpleasant tradeoff: help the economy now at the cost of hurting it in the future, or vice versa.  Not an easy dilemma to resolve.