Increasing Interest Rates To Encourage Credit Growth

by: Antonio Fatas

An article in yesterday's Financial Times by Bill Gross argues that Ben Bernanke has destroyed credit creation in the US by making the yield curve flatter in the 0-2 years horizon, with his statement that the Federal Funds rate will be zero for the next two years. According to the article, the flattening of the yield curve reduces lending by banks because it reduces the potential return to banks of borrowing short term and lending at a two-year horizon.

I understand that a strong recovery is normally associated with an upward slopping yield curve and the fact that we have a flat curve is bad news. But by committing to keep short term interest rates low for an extended period of time, the Fed is providing incentives for banks and investors to move into riskier assets (lending to companies and consumers) within that horizon. This should create lending, nor destroy it. This is what a macroeconomics textbooks say (including the one written by Bernanke). Reducing Fed rates does not change per se the returns of investment in other assets; it just makes the differential with the riskless asset even larger and creates an incentive to borrow/lend. There are many yield curves, one for each class of asset, and the Fed policy can only influence (directly) the one associated to riskless assets.

Of course, it can be said that Bernanke's action changed our expectations of the future and we are now more pessimistic than before, so lending will be destroyed after all, but this is not a direct consequence of lower interest rates but of the management of expectations.