TL/DR –
The Federal Reserve’s historically low interest rates, intended to stimulate investment and growth, have actually contributed to financialization and reduced the productive capacity of the U.S. economy, according to a Commonplace article. Non-residential investment has shown little correlation with interest rates over the past 25 years, and keeping rates too low for too long encourages debt accumulation, financial engineering, and worsening inequality, the article argues. Instead of driving productive investment, low rates have inflated asset prices, exacerbating income inequality, and encouraged government borrowing without corresponding increases in productive capacity.
A Close Examination of the Impact of Persistently Low Interest Rates
In the Federal Reserve Open Market Committee’s meeting this week, a primary topic of discussion will be whether it’s time to raise interest rates for the first time in three years. Despite President Trump’s clear preference for lower rates as a method to diminish the deficit and stimulate debt resolution, this widely-held view may not necessarily lead to better investment and growth. Overly low rates, kept low for extended periods, could lead to financialization, thereby reducing the productive capacity of the US economy.
Understanding Interest Rate Influence
The traditional economic perspective on how interest rates influence the business cycle isn’t entirely comprehensive. The Federal Reserve’s control over short-term interest rates for the economy is expected to stimulate growth when lowered, according to the neo-Keynesian theory that most Fed economic models are based upon. This theory suggests that decline in interest rates leads to decreased cost of capital for the private sector, encouraging them to invest productively, thus stimulating the economy and reducing unemployment. When inflation rises as a result of the economy overheating, the Fed raises interest rates, making borrowing more costly, slowing investment and growth, and ultimately reducing inflation.
However, in the last quarter-century, there has been little correlation between non-residential investment and interest rates. Although the Fed can control short-term rates, the primary factors driving investment cycles are factors beyond the Fed’s control, such as technology, trade policy, regulation, and animal spirits. The real impact of the Fed’s policy is seen significantly on asset prices. Persistently low interest rates encourage debt accumulation, financial engineering, and increased inequality. The economy is steered away from real economic activity and towards financial transactions, paradoxically reducing investment and growth from levels that could be achieved in a higher interest rate environment.
The History of Low Rates and Weak Investment Cycles
The investment portion of the GDP consists of residential and non-residential components. Over the past 25 years, non-residential investment has had a weak correlation with interest rates. This is a significant component of the GDP as it expands the capital stock and productive capacity of the country. Net domestic investment, which measures capital stock growth, has been declining as a share of the GDP for decades. Therefore, it is not surprising that real wages have stagnated. Moreover, as shown in recent research by American Compass, there has been an increase in companies that deplete fixed capital faster than they create new capital expenditures, even while returning cash to shareholders, partly due to the Fed’s interest rate policy.
Interest Rates and the Accumulation of Debt
Low interest rates encourage the accumulation of debt. In the last 25 years, total debt in the US across households, corporations, and the government has increased from 185% to 256% of the GDP. As each additional dollar of borrowing is generating less than a dollar of GDP growth, the overall trajectory shows rising leverage with diminishing returns. This unproductive debt prompts a vicious cycle where higher debt levels divert cash flows from investment to interest payments.
The Interplay of Interest Rates and Inequality
Another impact of perpetually low interest rates is elevated asset prices. Low interest rates in the early 2000s caused a surge in housing prices. Similarly, the stock market has benefited as investors were willing to pay higher multiples for future cash flows in a lower rate environment. However, the result of high asset prices is increased income inequality, as gains have been concentrated mainly among older households. The wealth that these households have acquired is largely used to sustain consumption, especially in sectors like healthcare and housing. Concurrently, rising inequality has increased barriers to upward mobility.
Impact of the Dollar, Capital Flows, and Deindustrialization
Despite low interest rates during the 2010s, the dollar strengthened as U.S. markets outperformed others across the globe, attracting foreign capital inflows. This led to a self-reinforcing cycle where rising U.S. asset prices attracted capital inflows, strengthening the dollar. However, a stronger dollar has significant consequences for the local economy as it makes exports more expensive, reducing the competitiveness of U.S. manufacturing and encouraging firms to offshore production to lower-cost regions, thereby contributing to deindustrialization and lower investment.
The Way Forward for the Fed
Considering the lack of investment effects in spite of low rates, it’s necessary for the Fed to reassess its approach. While the AI-driven capital investment cycle has the potential to deliver strong growth, full employment, and disinflation, there are already signs of rapid asset price appreciation and unsustainable debt accumulation. Higher rates won’t necessarily hinder the kind of investment the economy needs. On the contrary, they may promote that investment by curbing unproductive financial engineering activities.
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