Last week the Federal Reserve chose not to raise interest rates. It was the right decision. In fact, I’m among the economists wondering why we’re even thinking about raising rates right now.
But the financial industry’s response may explain what’s going on. You see, the Fed talks a lot to bankers – and bankers reacted to its decision with sheer, unadulterated rage. For those trying to understand the political economy of monetary policy, it was an “Aha!” moment. Suddenly, a lot of what has been puzzling about the discussion makes sense: just follow the money.
The basic principles of interest rate policy are fairly simple, and go back more than a century to the Swedish economist Knut Wicksell. He argued that central banks like the Fed or the European Central Bank should set rates at their “natural” level, defined in terms of what happens to inflation. If rates are too low, inflation will accelerate; if rates are too high, inflation will fall and perhaps turn into deflation.
By this criterion, it’s hard to argue that current rates are too low. Inflation has been low for years. In particular, the Fed’s preferred inflation measure, which strips out volatile food and energy prices, has consistently fallen short of its own target of 2 percent, and shows no sign of rising.
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It’s true that rates – near zero for the short-term interest rates the Fed controls more or less directly – are very low by historical standards. And it’s interesting to ask why the economy seems to need such low rates. But all the evidence says that it does. Again, if you think that rates are much too low, where’s the inflation?
Yet the Fed has faced constant criticism for its low-rate policy. Why?
The answer is that the story keeps changing. In 2010-11 the Fed’s critics issued dire warnings about looming inflation. You might have expected some change in tune when inflation failed to materialize. Instead, however, those who used to demand higher rates to head off inflation are still demanding higher rates, but for different reasons. The justification du jour is “financial stability,” the claim that low interest rates breed bubbles and crashes.
I suppose this latest excuse for raising rates could be right. But it’s striking how convoluted and dubious the case for rate hikes has become. I like to think of it this way: if left-leaning politicians were to offer rationales for their policies that were this dependent on shaky logic and weak evidence, they would be lambasted for their irresponsibility. Why does anyone take this stuff seriously?
Well, when you see ever-changing rationales for never-changing policy demands, it’s a good bet that there’s an ulterior motive. And the rate rage of the bankers – combined with the plunge in bank stocks that followed the Fed’s decision not to hike – offers a powerful clue to the nature of that motive. It’s the bank profits, stupid.
Many people have been led astray here by trying to figure out whether easy money is good or bad for wealthy people in general. That’s actually a complicated question. What’s clear, however, is that low rates are bad for bankers.
For banks make their profits by taking in deposits and lending the funds out at a higher rate of interest. And this business gets squeezed in a low-interest environment: The rates banks can charge on loans are pushed down, but rates on deposits can only go so low. The net-interest margin – the difference between the interest rate banks receive on loans and the rate they pay on deposits – has fallen sharply over the past five years.
The appropriate response of policy makers to this observation should be, “So?” There’s no reason to believe that what’s good for bankers is good for America. But bankers are different from you and me: they have a lot more influence. Monetary officials meet with them all the time, and in many cases expect to join their ranks when they come out on the other side of the revolving door. Also, it’s widely assumed that bankers have special expertise on economic policy, although nothing in the record supports this belief. (The bankers do, however, have excellent tailors.)
So we shouldn’t be surprised to see institutions that cater to bankers, not to mention much of the financial press, spinning elaborate justifications for a rate hike that makes no sense in terms of basic economics. And the debate of the past few months, in which the Fed has seemed weirdly eager to raise rates despite warnings from the likes of Larry Summers that it would be a terrible mistake, suggests that even U.S. monetary officials aren’t immune.
But the Fed did the right thing last week: nothing. And the howling of the bankers should be taken not as a reason to reconsider, but as a demonstration that the clamor for higher rates has nothing to do with the public interest.