Low Interest Rates have become a Self-fulfilling Prophecy
So the Fed has kept interest rates at their rock bottom. Will they ever be able to raise them? Let me take a closer look…
Tim Taylor writes about the impact of low long-term interest rates. He ends his post with this quote…
“The BIS report raises the uncomfortable question of whether we are riding a merry-go-round in which sustained ultra-low interest rates bring financial weakness in various forms, and then the financial weakness is the justification for continuing ultra-low interest rates.”
The idea is that ultra-low interest rates have become a self-fulfilling prophecy in that they have led to conditions that further justify them.
I wrote about this issue last December here on Angry Bear. (link) All I had to do was search for “self-fulfilling prophecy” to find the post. The IS-LM model was used to show how low interest rates beget low interest rates when one sees full-employment much greater than it really is. Full-employment is when output reaches its potential.
Tim Taylor includes this point in his post referring to a BIS article…
“After all, pre-crisis, inflation was stable and traditional estimates of potential output proved, in retrospect, far too optimistic. If one acknowledges that low interest rates contributed to the financial boom whose collapse caused the crisis, and that, as the evidence indicates, both the boom and the subsequent crisis caused long-lasting damage to output, employment and productivity growth, it is hard to argue that rates were at their equilibrium level. This also means that interest rates are low today, at least in part, because they were too low in the past. Low rates beget still lower rates. In this sense, low rates are self-validating.”
From the point of view of Effective Demand, the economy is already at potential output as seen in the following graph. Blue line is how effective demand sees the output gap. Orange line is how the Fed and CBO see the output gap. (Keep in mind that the CBO keeps adjusting potential output to be less optimistic. They still have a lot of adjustment left, but they cannot make huge adjustments at once. So we are stuck with a CBO potential output that must slowly come back to reality.)
This point was also reflected in a post by Paul Krugman today where he sees the Fed’s projection of the NAIRU receding over time. (link) The confusion of the potential is rooted in why inflation keeps being so weak. There are reasons for continued weak inflation even in spite of the US economy being at full-employment and potential output.
From the point of view of effective demand, once again the view of potential output is far too optimistic. I do not see a negative output gap. The business cycle has already closed the gap. The post I wrote last December uses the IS-LM model to show how the interest rate will stay low when the view of potential output is too optimistic. (I will not repeat that post here. You can read through this link.)
I will finish this post with a comment that I made to Julian Silk under that post from last December.
It is somewhat prophetic.
“Inflation has a good chance to fall below 1%. What should the Fed do? They will not be able to raise the Fed rate. They are too far behind the curve now.
There was a window that they had to go through a couple years ago in order to start raising rates. They had to bite the bullet and challenge the markets at that time. There has to be more destruction in the economy in order to have more productive firms. The markets needed discipline but the Fed kept babying markets. The economy is now basing its production and investment decisions upon low rates. They know that the Fed is incapable of disciplining. The Fed cannot risk a downturn from disciplining the markets. The markets had resilience a couple of years ago but not now.
So I agree with you that rates will not rise. Money demand is not going to be strong on its own. The Fed has been forcing artificial money demand for too long. In general the economy still wants to save. There should have been much more fiscal stimulus.
So now I say that the liquidity trap has become a self-fulfilling prophecy. The Fed was unable to discipline the markets. Now they are weak and accustomed to being spoiled even though profits are high. The system is not working. Standards of excellence have fallen. The economy is decaying.”
Krugman is going to dislocate a joint with all this patting himself on the back about his widget-based predictions. I wish I could get my time back whenever I go to his site only to discover that he’s just replaying the same old rant.
You didn’t need economic widgets to guess what would happen post-crisis , all you needed was a bit of familiarity with Japan post-1990. Many of us non-economist blog commenters were saying we were “turning Japanese” when U.S. QE was still in potty-training.
He bashes the BIS every chance he gets , but they were out front on the warnings about debt before the crisis , and Krugman is still suffering from the embarrassing ass-ream he got from Keen about debt-fueled growth. Remember his loony whining about how he just didn’t get that – because borrower spending is offset by lender non-spending ? I think he still doesn’t really get it. He seems to know that deleveraging is bad for growth , but the part about leveraging promoting growth – unsustainably – stumps him , so naturally inflation is the only metric he cares about when pondering “potential” growth rates.
Today he says : ” …..Again, if someone from the center-left were to produce an economic analysis this tendentious, this much at odds with decades of mainstream economics, it would be met with incredulity. ”
My God , man , wake up ! Decades of misguided mainstream economists have landed the global economy squarely in the shitter , and the only plausible way out that I can see is if the economy and the economists exchange places.
Then flush , and we might get back to a healthy “equilibrium”.
Ignoring Japan, every time we’ve lowered rates since the 80’s they have bottomed out lower and stayed lower longer.
The US economy is no longer the economy it was in the 1970s.
I missed all that about the BIS. Got a link?
This taylor is a real piece of work.
“If one acknowledges that low interest rates contributed to the financial boom whose collapse caused the crisis, and that, as the evidence indicates, both the boom and the subsequent crisis caused long-lasting damage to output, employment and productivity growth, it is hard to argue that rates were at their equilibrium level.”
I’m sorry, but the FED raised rates on a continuous basis from 2003 through 2007. Somehow, those rate increases had no effect whatsoever on the financial boom. Now he concludes that low interest rates caused the boom.
Shouldn’t he have to show how the boom kept going even after the FED rate was raised 400% in order for his statement to not be beyond silly?
From my models, the Fed rate was not loose before the crisis. Maybe in 2005, but it was a bit tight in 2007 before the recession. The Fed did a good job keeping a balanced Fed rate after the 2001 recession.
The point I see is that low rates in and of themselves beget low rates when you are in an environment of low domestically productive investment and high asset value investment. The domestic economy gets weak and unproductive.
With capital flowing back to the US dollar, this puts pressure to lower interest rates again… The Fed really wanted to normalize the Fed rate, but it can’t happen anymore in this biz cycle. I have been saying since last year that the Fed will go through a deep period of soul-searching to try to understand why policies are not working.
I can see why, because they keep thinking potential is a far way off, when it has already been here, right under our noses.
Here’s one of the earlier BIS papers (2004) :
It was Borio and White who were most active in sounding the alarm , as I recall , so you can try looking at some of their papers/speeches from ’04-’07 to get a feel for it :
On Taylor , I think his argument would be that the Fed held rates ” too low , for too long ” , deviating wildly from his favorite , easy-to-follow rule :
I don’t know if raising rates sooner would have made much difference given the global liquidity that was sloshing around. And a major factor in the bubble after 2003 or so was the criminally sloppy underwriting that allowed anyone who could fog a mirror to buy a $500k house. Those buyers would have signed up at any interest rate.
To me all this talk about raising the rate has become a catch 22 now. darned if you do abut screwed if you don’t effect has been created out of the stupidity of the Fed lack of leadership. It goes back to corruption of many and the bubble creations that served the very few to get us to where we are today as a broken down system that is so far out of wack that the old way of kick starting the system just ain’t workin no more . I’m sure that Yellen and Obama just don’t know what to do when we have corrupted markets in gold, oil ,China, labor rates, unemployment, all from greed and globalization. The 1% ers are winning bigger gains than ever while the rest of us scratch our noses and try to figure a new way to game the system from the Bureau of Liars Statistics… I was wondering if you folks ever read PCR.org or WallStreetonParade.com to get to the more real story-reasons as to the hows and whys things are the way they are and ain’t working the old way no more. This is why we are seeing the political revolution of 2015 taking place with Trumpism.
I do not disagree with you at all, just with Taylor’s inanity.
I am totally lost by your argument about the BIS and see nothing in their work that shows they had any kind of insight at all.
I appreciate Tim Taylor. His posts explore ideas and educate.
” I am totally lost by your argument about the BIS and see nothing in their work that shows they had any kind of insight at all. ”
Before the crisis , that inability to “see” was widespread. Post-crisis , it’s a sign of a troubling disorder : Kool-Aid-induced blindness. ( Also , deafness ) :
“The Man Nobody Wanted to Hear: Global Banking Economist Warned of Coming Crisis”
“…Another expert who dissented from the Greenspan-Bernanke line was William White, the former economics adviser at the Bank for International Settlements, a publicly funded organization based in Basel, Switzerland, which serves as a central bank for central banks. In 2003, White and a colleague, Claudio Borio, attended the annual conference in Jackson Hole, where they argued that policymakers needed to take greater account of asset prices and credit expansion in setting interest rates, and that if a bubble appeared to be developing they ought to “lean against the wind”—raise rates. The audience, which included Greenspan and Bernanke, responded coolly…
…Between 2004 and 2007, White and his colleagues continued to warn about the global credit boom, but they were largely ignored in the United States. “In the field of economics, American academics have such a large reputation that they sweep all before them,” White said. “If you add to that the personal reputation of the Maestro”—Greenspan—“it was very difficult for anybody else to come in and say there are problems building.”
The FED raised rates constantly during the period in question..
What? You wanted them to go from 1 to 20?
As you mentioned earlier, FED rates had nothing, zilch, zero, bupkus to do with the housing bubble.
Now you are trying to say it did.
I remember right after Bush stole the election in 04 Greenspan warned of “irrational exuberance” and the markets went crazy.. A few short years later the market crashed from derivatives swaps in the housing market. today we can see the same scenario playing out only this time it is the derivatives in the energy market but we are at 0 in rates this time round…Please go see today’s Wallstreetonparade.com for further explanations, better critical thinking and analysis.
So the question is, how do we get out of the low-interest rut?
Warren let me connect a few dots for you. Once we get Trump in office you will then shortly after have to raise rates a bit because the economy will start to pick up steam. I know you guys don’t like uncertainty but this is the only way we can go now. No more Bushes or Clintons or we are doomed. Trump will take the stand he says against all the great powers against America in the world. Nobody else on the stage can or will do this. We need badly close the border and put on the variable rate tariff to balanced trade to bring back our economy so you can raise your rate. Get it?
The message of Borio and White , which is as valid today as it was in 2003 , is that the inflation rate of goods and services is insufficient as an indicator for determining the monetary policy stance , and that asset price behavior should be considered as well.
The problem with this is that economists’ brains are set – they’ve been programmed to respond in a certain way , and even when they’re consumed with doubt , they always revert back to the old program.
For 3+ decades we’ve had falling interest rates globally as an understandable response to periodically flagging demand. During the same period we’ve seen growing economy-wide leverage , as the rate of debt growth exceeded the rate of economic growth , in stark contrast to the pre-1980 pattern of stable overall leverage. Also at the same time we’ve seen an increase in the occurrence of asset bubbles , in both equities and real estate. This pattern tells you something , but economists have been well-trained not to listen.
This pattern is exactly what you’d expect to see under a policy regime that has incrementally but relentlessly favored the redistribution from labor to capital , which is just what we’ve seen over these recent decades. In broad strokes , capital accumulates while labor consumes. When labor no longer has income to consume , you can substitute credit for income , but can only sustain this by continuously reducing interest rates. Some don’t see this as a problem , and rather like what has happened over the last 30 years , but can they describe what the world will look like when we get to interest rates of minus 20% ? Minus 100% ? Do they know how angry some of us are already ?
Krugman’s brain , in spite of its defective programming , is trying to lead him into the light. In today’s article , he cites an article from the ’40’s , which dismisses the efficiency gains of trade if they come at too great a cost in the distribution of incomes. He needs to read more of that 1940s economic literature.
Go towards the light , Paul.
Go to the light.
You make some good points and how weakening labor income and the increase in debt have lowered interest rates. These factors lead to interest rates going even lower, because low interest rates encourage more debt and are used as a substitute for raising labor income.
Those are two good points for why low interest rates have become a self-fulfilling prophecy.
I believe that somewhere along the line, the Fed just came to the conclusion that raising or lowering the interest rates was all the influence they needed to control the economy
It never seems to have occurred to them that the interest rate tool had its limits. Or that regardless of how low interest rates went, more and more consumers would find their access to credit more limited because of their total household debt.
There is a limit as to how low consumer incomes can go, and how high consumer debt can go. As you approach those limits, economic activity has to be reduced.
Or to put it another way, the financiers in this country need a viable mainstream economy to play with. (Sarcasm intended)
Here’s a good takedown on our insane progression towards negative rates , cashless societies , etc. :
The 1% really have it all figured out. They keep the public distracted by getting the politicians to focus on hot-button crap like Planned Parenthood , and keep the econ community distracted by limiting the discussion to irrelevant monetary policy.
A couple more bubbles/busts from now and they’ll own the whole shebang , and Krugman will still be ranting about how he won the inflation debate. Bravo , Kruggers. Well done.
per Robert Shiller: “The term “irrational exuberance” derives from … a black-tie dinner speech … December 5, 1996… As far as I can determine, Greenspan apparently never actively used the words “irrational exuberance” again in any public venue. “
“It never seems to have occurred to them that the interest rate tool had its limits.”
I have always understood that they knew it had limits. It’s just that the other tools are controlled by others. Fiscal policy requires legislative compromise. If one side has no need for compromise, there will be no compromise.
My first (and only) law of economics, “Nothing happens until somebody buys something”.
And while low rates allow people to buy more somethings or more expensive somethings, the limit is a combination of rates and income.
We reached the limit on low rates awhile ago, and now people have adjusted to that. The problem now is due to the lack of income.
The peak labor share was in 1970, at 58.4%. That was down to 52.7% in 2014. (BEA data)
Net Operating Surplus have gone from 20.7% to 25.1%. Inside that is this little nugget: Rental income has gone from 1.9% to 3.5%.
Actual after-tax profit has gone from 4.1% to 6.5%.
Also, we have consumption of fixed assets rising from 12.8% to 15.6%.
Those three account for all of the drop in labor share.
Labor share tends to rise going into recessions? And fall coming out?
Sure seems that way, doesn’t it, Arne? Any explanations?
More competition for labor drives up labor prices (and labor share) and reduces capital investments, and efficiency suffers, eventually leading to recession?
How about this theory;
Part of a general path for growth has companies hire new employees to make new products that their marketing departments predict can be sold for a profit. Success in selling leads to marketing deciding they can sell more, so firms increase their output. To do so, they have to hire more workers and even pay them more, which puts more money into the economy so demand increases and more units can be sold.
Instead of forecasting that the market will saturate, human beings forecast that the market will keep growing. Eventually marketing notices that they are no longer selling all their units and they have to pull back. The forecast failure occurs when inventory is high and when employment has gone past what steady-state growth would require. We end up in recession. Forecasting as firms do it is inherently unstable.
Cross-industry interaction provides some damping through reversion to the mean, but there is also an unstable component because hiring workers and giving money to them to be consumers is a shared pool.
In a primarily manufacturing economy, that would make more sense. But it seems to me we are more in a service economy, and service companies tend not to hire until it is less expensive to hire than to pay current employees overtime. In service businesses, supply follows demand more than it anticipates demand.
But I am NOT in the service business, so it may be that they, too, try to predict demand and hire early to be able to meet it. I do not know.