Several months ago, the Fed stated its desire to lower long-term interest rates, and it has consequently increased its purchases of long-term Treasuries. Empirical studies, however, suggest that the effect of these purchases is nowhere near powerful enough to explain the persistent decline of long-term interest rates. The ten-year Treasury, for example, has gone from about 5.25 percent in 2007 to just over 2 percent today. If these purchases were truly adding a large monetary stimulus, we would expect to see long-term interest rates rise, not fall, from the resulting higher expected inflation and, to the extent the stimulus works, an improved economic outlook.
The proximate reason, then, for the low-interest-rate environment is that the ongoing weak economy has stirred investors’ appetite for safe and liquid assets. Households, for example, continue to hold an inordinately high share of money-like assets, including Treasuries, in their portfolio of assets, as the graph below shows.
Households’ high share of safe assets should not be surprising given the spate of bad economic developments over the past five years: the Great Recession, the euro-zone crisis, concerns about a China slowdown, the debt-ceiling dispute of 2011, and the more recent fiscal-cliff talks. The immediate effect of these developments was to create uncertainty about future economic growth and raise the demand for money-like assets. This elevated broad money demand not only has kept interest rates low, but also has prevented a robust recovery from taking hold.
While this absolves the Fed of direct responsibility for the low-interest-rate environment, it does not absolve it for its indirect influence. Through its control of the monetary base, the Fed can shape expectations of the future path of current-dollar or nominal spending. Thus, for every spike in broad money demand, the Fed could have responded in a systematic manner to prevent the spike from depressing both spending and interest rates. In other words, the Fed could have adopted a monetary-policy rule that would have committed it to maintaining stable growth of total-dollar spending no matter what happened to money demand. A promise from the Fed to do “whatever it takes” to maintain stable nominal-spending growth would have done much by itself to prevent the money-demand spikes from emerging at all. Why hold a greater number of safe, liquid assets if you believe the Fed will keep the dollar value of the economy stable?
There is a name for this rule-based approach to monetary policy: nominal-GDP targeting. It would keep nominal spending stable while also adding more long-run certainty to the nominal incomes of households and firms. Additionally, with this approach, the Fed’s balance sheet would not be blown up by ad hoc large-scale asset-purchase programs. The Fed’s failure to adopt something like a nominal-GDP target in 2008 meant that the central bank would not be able to adequately respond to the subsequent money-demand shocks that arose over the next four years. That is, the Fed’s inaction allowed the pernicious low-interest-rate environment to develop. So while the Fed did not directly cause the low-interest-rate environment, our central bank allowed it and all of its associated problems to emerge. For that it should be blamed.
— David Beckworth, formerly an economist with the U.S. Department of the Treasury, is an assistant professor of economics at Western Kentucky University and editor of Boom and Bust Banking: The Causes and Cures of the Great Recession.