Fed President Fisher Explains Why Rates Are So Low

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By Hale Stewart

Recently, Donald Trump accused the Federal Reserve of deliberately keeping rates low for purely political gain. Several other Republican Congressmen and bloggers have made similar allegations. But these pronouncements run counter to empirical data. For example, earlier this year, the San Francisco Federal Reserve released a study showing that the current level of interest rates are in fact at the same level as the "natural" rate of interest. And last week, governor Stanley Fisher gave a speech that provided 4 reasons rates currently low level.

He first discussed the negative impact of low productivity growth on overall GDP growth along with interest rates:

Going through the four major forces I just mentioned, I will look first at the effect that slower trend economic growth, both on account of the decline in productivity growth as well as lower labor force growth, may be having on interest rates. Starting with productivity, gains in labor productivity have been meager in recent years. One broad measure of business-sector productivity has risen only 1-1/4 percent per year over the past 10 years in the United States and only 1/2 percent, on average, over the past 5 years. By contrast, over the 30 years from 1976 to 2005, productivity rose a bit more than 2 percent per year. Although the jury is still out on what is behind the latest slowdown in productivity gains, prominent scholars such as Robert Gordon and John Fernald suggest that smaller increases in productivity are the result of a slowdown in innovation that is likely to persist for some time.4

Lower long-run trend productivity growth, and thus lower trend output growth, affects the balance between saving and investment through a variety of channels. A slower pace of innovation means that there will be fewer profitable opportunities in which to invest, which will tend to push down investment demand. Lower productivity growth also reduces the future income prospects of households, lowering their consumption spending today and boosting their demand for savings. Thus, slower productivity growth implies both lower investment and higher savings, both of which tend to push down interest rates

The following charts illustrate the above points:

Click to enlarge

Click to enlarge

Productivity is a very important economic number: higher productivity leads to more output which means it's easier for overall living standards to increase at the macro level. The top chart is a long-term chart of labor productivity; the bottom chart is for total business productivity. Both are low for the last 60 years. Some economists have argued that low productivity growth is the primary reason for this recovery's low top-line GDP growth. While this assertion is debatable, there is no doubt that low productivity is in part responsible for weak growth.

He next argued that an aging population is contributing to low rates:

In addition to its effects on labor force growth, the aging of the population is likely to boost aggregate household saving. This increase is because the ranks of those approaching retirement in the United States (and in other advanced economies) are growing, and that group typically has above-average saving rates.9 One recent study by Federal Reserve economists suggests that population aging - through its effects on saving - could be pushing down the longer-run equilibrium federal funds rate relative to its level in the 1980s by as much as 75 basis points.

Here, Fisher is making a macroeconomics 101 argument. As people age, they set aside more funds for retirement. This increases deposits at banks and other financial intermediaries, increasing the supply of loanable funds. As supply increases, price (interest rates) drop. Remember that this trend is happening not only in the U.S. but also the EU and Japan. And here's a very important point to remember for future reference: it will start to happen in China within the next 10-15 years.

A third factor is weak investment:

In addition to slower growth and demographic changes, a third factor that may be pushing down interest rates in the United States is weak investment. Analysis with the FRB/US model suggests that, given how low interest rates have been in recent years, investment should have been considerably higher in the past couple of years. According to the model, this shortfall in investment has depressed the long-run equilibrium federal funds rate by about 60 basis points.

The current level of nonresidential investment is very low, as shown in the following chart:

Click to enlarge

During the current expansion, investment/GDP ratio peaked at 13%, which is below the peak of the previous 2 expansions. If current investment demand was high, this expansion's current low rates would imply that business had been under-investing, meaning they'd need to play catch-up. But that isn't happening. Instead, business is investment at lower levels. This shows that businesses aren't demanding the funds, which puts downward pressure on interest rates.

Finally, there is weak international demand:

Many of the factors depressing U.S. interest rates have also been working to lower foreign interest rates. To take just one example, many advanced foreign economies face a slowdown in longer-term growth prospects that is similar to that in the United States, with similar implications for equilibrium interest rates in the longer run. In the FRB/US model, lower interest rates abroad put upward pressure on the foreign exchange value of the dollar and thus lower net exports.

The US is not the only economy experiencing slow growth; the EU and Japan are both mired in weaker than desired macroeconomic environments, China, while still enviable at 6.7% growth, is slowing as are the emerging markets.

As Fisher clearly shows, there are many empirical reasons supporting low interest rates: low productivity growth, an increased supply of savings, weaker investment and overall slow global growth. This is not a case of the Fed supporting or even promoting one political party; instead, low rates are a direct result of structural factors. And until those are dealt with, we'll remain in a low rate environment.

Hale Stewart, XE.com