The Economy Will Survive Normal Interest Rates Just Fine

On November 25, 2008 the Federal Reserve Board announced the beginning of quantitative easing, what we now know as QE1. The next day, the rate on ten year U.S. government bonds dropped below 3 percent for the first time since the 1950s. Rates have stayed below 3 percent for over two-thirds of the time since then, through QE2, Operation Twist, and the current QE3.

Everybody expects the Fed to begin ending QE3 soon, most likely announcing a taper after their September meeting ends on Wednesday this week. Investors in the stock and bond markets are very nervous about what will happen when the Fed stops artificially depressing interest rates. They should relax. Interest rates have been so low that they have been hurting the economy. Having rates move back toward normal levels will be good for the economy.

First, and most importantly, people should understand that interest rates are not going to move upward very far. The federal government cannot afford to pay normal interest rates on the national debt. The debt is too big. Currently net interest payments on the debt are running around $220 billion per year. (Net interest payments do not count the interest that accrues on debt the government owes to itself such as bonds held by the Social Security Trust Fund.) That implies the average interest rate on debt held by the public is approximately 1.9 percent.

If interest rates rose enough to double the government's average interest rate paid, that would add another $220 billion to the deficit, a significant increase. If the average interest paid went all the way to 5 percent, a level that the ten year bond rate has been above for about 70 percent of the last fifty years, the interest payments would add an additional $360 billion per year to the annual deficit and the national debt.

The government does not want to spend that much extra money on interest on the debt and will pressure the Fed to keep rates low through one mechanism or another until either the deficit is lower or the debt can be reduced in real terms through inflation. Neither appears likely to happen anytime soon, so any increase in interest rates that occurs with the end of QE3 will not be allowed to be too large.

Second, as just noted, interest rates on the ten year bond have normally been over 5 percent, while they are now slightly below 3 percent. The economy has done fine with the ten year rate over 5 percent, as have the stock and the bond markets. Under President Clinton, the S&P 500 index averaged a 17.4 percent annual return while the ten year rate was over 5 percent for all but a few months of his presidency (and peaked briefly at 8 percent).

I certainly do not discount the probability of some sizeable market adjustments shortly after the Fed officially announces the taper to QE3 and for several months afterward as the markets and investors resolve their uncertainty over how much rates will rise and how active the Fed will be going forward. However, a consensus will develop and the markets will settle down.

The economy is actually less connected to the stock and bond markets than many people think. So having perhaps convinced you that the stock and bond markets might be okay without so much help from the Fed, how will the economy do?

The consensus view of most economists is that low interest rates boost investment, thus helping the economy. This is certainly true to a point, but there comes a point where lower interest rates do not lead businesses to increase their investment in new plants and equipment.

Businesses make investment decisions by comparing the expected returns of an investment project to its cost. Generally, the business will compute the expected return as what economists and accountants call an internal rate of return. The internal rate of return is the interest rate at which a business would just break even on the investment project if it borrowed all the money to pay for it. Lower interest rates mean that more projects a business is considering will be profitable because the cost of funding the project is lower while the returns are unchanged.

However, a business generally will not consider investments below some set internal rate of return, no matter what the interest rate is. New projects carry risk and add complexity to a business. The business owners and managers will not willingly undertake new investment projects that promise only slim rewards. The potential reward must be sufficient to make the risk, effort, and hassle worth it. This minimum rate for a project to be considered is often called a hurdle rate, because it is a hurdle that any successful project must clear.

For example, imagine a company which has a rule that it will not consider investment projects with an internal rate of return of less than 7 percent and only invests in projects where its cost of funds is at least 3 percent less than the estimated internal rate of return. Further, imagine that this company has a range of possible projects under consideration with estimated internal rates of return ranging from 13 percent down to its lower limit of 7 percent. Such a company could be encouraged to boost its investment spending if interest rates were lowered from 8 percent down to 4 percent, with more projects becoming attractively profitable as rates drop.

But once rates get down to 4 percent, further declines in interest rates cannot convince our imaginary company to increase investment because it already is going forward with all the projects it is willing to undertake. Pushing interest rates even lower stops being a stimulus to investment at some point. Lowering rates too far is simply pointless.

The Fed and many macroeconomists have just assumed that the effect of interest rates on investment that has been observed in the past would continue even though rates have been lowered to levels that have not previously been observed in those economists' data sets. When a variable exceeds the range of the data used to estimate our economic models, the model users need to use extreme caution in assuming the economy will behave in the unobserved range as it has in the past.

If lowering interest rates too much does not help the economy by boosting investment, it likely hurts the economy by reducing consumption due to the loss of income from interest paid on savings. Millions of Americans who have responsibly saved money have seen the earnings from those savings decimated over the last five years in the face of savings account, money market, and CD interest rates that have often approached zero. This decline in interest income means these people, many of them senior citizens, have less disposable income and are forced to spend less.

If the Fed allows interest rates to rise, these savers will quickly see an increase in their income which should translate into a rise in consumer spending. This will help businesses and might actually increase investment more than low interest rates. After all, when consumer spending rises businesses will estimate higher future returns for new investment projects under consideration because they will project higher consumer demand for their products.

When the Fed begins its taper of QE3, the rise in rates will likely be small in a big picture sense. If interest rates go up a percent or two from the current level, they will still be on the low end of historical norms for the U.S. over the past fifty years. While firms will face somewhat higher borrowing costs which may cause them not to go forward with some new investment projects, most businesses have hurdle rates so far above the current interest rates that this effect will likely be small. Offsetting this effect, savers will see gains due to increased interest income received on their savings. This will be a welcome change for many senior citizens who rely on income from savings to help pay their retirement expenses.

Markets may be volatile as the Fed tapers, but they will survive and have shown they can perform just fine with interest rates much higher than we are likely to see anytime soon. Remember, investors did very well in the Clinton years with interest rates that averaged 6.15 percent. Savers will benefit from earning higher interest rates, leading to consumer spending gains. Finally, given that everybody knows what the Fed is going to do, just not exactly when, markets have already made much of their adjustment to new higher future interest rates. The Feds clear signaling of its intentions should reduce the volatility that can be expected when the taper actually begins.

The record low interest rates that the Fed manufactured with Quantitative Easing and Operation Twist have not provided much of a boost (if any) to the economy. Allowing them to move toward the low end of the normal range for U.S. interest rates will not kill the recovery. If lowering rates provided limited benefits, higher rates should similarly see quite limited damage. In the short run, markets may be very volatile as investors finish adjusting to the new interest rate regime. However, like the sequester budget cuts, the Fed taper will probably end up being a non-event once the short term uncertainty is resolved.