The U.S. Federal Reserve building in Washington.JIM YOUNG
Avery Shenfeld is chief economist at CIBC World Markets
Sometimes the conventional wisdom is, in fact, wise. Generations of economists have been taught that in an economy suffering from insufficient demand and high unemployment, low interest rates are the right medicine. And if inflation is low enough and unemployment stubborn enough, as it is in the U.S. today, the appropriate policy rate is only a hair above zero.
Recently, The Globe and Mail has featured the contrarian views of finance professor Rahghuram Rajan, who seems to have skipped a few ECO 100 classes en route to his current post. Mr. Rajan argues that the U.S. Federal Reserve should be raising rates, despite agreeing that the economy is in trouble.
But there are major gaps in his line of reasoning. For one, he himself concludes that raising rates would be "neutral" for growth, hardly a stirring endorsement for a policy shift.
Moreover, his view that low rates aren't helping out seems to be tied to observations on the weak state of demand for durable goods, capital spending and housing. True, these sectors have not shot up in the way they typically do in the face of interest rate cuts, but that reflects the hangover from a deep financial crisis.
What matters is that low interest rates have these sectors doing better than they would be if borrowing costs were higher. Since interest rates are simply a price in the economy, you would have to throw all of economics out the window to argue otherwise. Housing prices and construction would be falling even more sharply if mortgages were more expensive. Businesses would find fewer projects worth undertaking if their cost of debt capital was higher. Ask the car dealers if they could sell more vehicles at a higher leasing rate.
Mr. Rajan's other argument is that low rates hurt the incomes of savers, leaving them less to spend. Again, this is another fallacy. Households are roughly evenly balanced between those paying interest, typically younger families who spend most of their income, and those receiving it, often higher income households that save a greater portion of their income. Shifting income from the former to the latter might actually reduce spending. Indeed, a lower interest rate is specifically aimed at encouraging those who have money to spend it now (while the economy needs it) rather than save it for later.
Mr. Rajan is concerned about the prospect that low interest rates encourage investments in risky assets. But improving flows into equity markets and corporate bonds will again help finance much needed capital spending. The run-up in commodity prices, which Mr. Rajan ties to low U.S. rates and sees as a hurdle for American growth, is instead more attributable to inappropriate monetary stimulus in emerging markets.
Do ultra-low interest rates have any costs? Only if they spark an inflation problem. With American wages actually decelerating, there simply isn't enough spending power in the U.S. economy to worry about that just yet.
Thankfully, we have Ben Bernanke, not Rahghuram Rajan, at the helm of the Fed in these troubled times.