Just a quick question. I know there’s an adage that you don’t raise interest rates in a recession. Of course I don’t know of any recession in the past where interest rates were essentially zero.

My theory is that raising interest rates would cause both business and consumers to buy so that they could lock in today’s rates. I think the main reason we’re not recovering is that there’s no reason for businesses or consumers to “buy now”. If the fed started raising rates people would want to re-fi. They’d want to buy a new car. Any large purchase they’d been putting off they’d potentially make to avoid having to spend more in the future. Obviously you can’t raise rates forever, but we know an economy can run just fine with interest rates in the middle single digits so why not try?

What’s the flaw in my logic?

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Comments

Troy

2010-09-12T07:56:26.000Z

Let me start with Japan. That country has had essential zero percent interest rates from the early 90s. Nothing like that in the US until this most recent recession, but Japan is a perfect example of a developed economy with zero percent interest rates for a long long time. In regards to your second point, say the Fed announced they would increase interest rates in six months. Yes, I agree that people and businesses would probably lock in capital purchases now, and would spur some investment now, but what would happen after interest rates increased? As we have seen with the stimulus, there have been two great examples in which cash/tax credits created an market that was artificially boosted, but did not create long-term demand: cash for clunklers and the home buyer tax credit. The incentives embedded in these programs artificially created more interest in buying cars and homes, but after they ended, we essentially came back to recession level purchasing. I think we would get the same results with your idea, with even more dire consequences, since we would be returning to a more difficult interest rate environment and not the status quo. Right now, we are in a possible deflationary cycle, which causes people to hold off buying anything because they can just wait a few months to buy that TV or that car because it will be cheaper in a few months/years. By increasing interest rates, we would accelerate deflation since higher rates (leading to higher cost of investment/production, and higher units costs) would decrease demand, and one way to spur demand would be for businesses to reduce prices. Keeping interest rates low spurs investment bc money is cheap and investors want a return above low interest bearing US Treasury bonds. They will plow the money into corporate bonds or equities, which puts money in businesses, and hopefully get the economic cycle started up again. However, people are scared because they don’t want to lose any money, and fear is causing folks to keep their money in very safe (i.e. govt bonds despite what the conservative media and the Right say) places and not in businesses. Does that make sense?

Tim (http://www.loadedguntheory.com/blog/index.php/listblog/.html)

2010-09-13T01:34:49.000Z

The difference seems to me is that like a stimulus it might only have a short term bump, but unlike a stimulus it doesn’t cost anything. I’m not really advocating a massive increase, just enough that the fed could actually move the markets and give people the impression that they had any ability whatsoever to do anything about the current environment. Even bumping it 1% in quarter increments gives them 8 months minimum of up-and-down where they can appear to be doing something.

Troy

2010-09-13T07:07:32.000Z

Any sort of indication that rates are going up would be a massive statement by the Fed, and would indicate that we are raising rates for the long-term. You just dont raise rates, then lower them as a policy. If our policy was to raise rates, even by a quarter percent, for 6 months, then anybody with sense would wait until rates went back down. It just wouldn’t work.

Tim

2010-09-13T07:18:53.000Z

Who are these people with sense you’re referring to? If people had any sense they wouldn’t be buying bonds with next to 0 rate of return. I feel like there are these standard economy textbook answers to things that get stuck in recursive loops. The text seems to be: 1) If economy is bad cut interest rates. 2) Raising interest rates makes economy bad. So what happens if the economy is bad and you can’t cut interest rates. You just hit a recursive loop until your run out of memory (money)?

Troy

2010-09-13T08:31:59.000Z

You are correct, for the investor, they would prefer the higher return, but for the business that needs to borrow to expand their business, this would be bad, very bad, especially if they knew interest rates were on the rise. Now rising interest rates does not necessarily make the economy “bad”. It helps to cool down a possibly overheated economy and reduce inflation. And that is “good”. Problem with the Fed is that the economy is bad and you can’t cut short-term interest rates any more. The hope in 2009 was that the federal stimulus would be a fiscal policy response (Keynesian) to kickstart the economy. Evidently, that hasn’t worked, or hasn’t worked well enough. What are our next options? More stimulus? Good luck with that. Balance government budgets? I think that is a mistake.