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.)

update output gap 1

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.”