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Janet Yellen made the right call

The case for keeping interest rates as low as possible for as long as possible.

Win McNamee/Getty Images

The Federal Reserve made big news today by doing nothing — higher interest rates are not coming this month.

That's the outcome that most observers were expecting over the past week, but a considerable minority of voices has been calling for higher interest rates all summer. The economy, after all, is much stronger right now than it was five or three or even one year ago. We could surely survive without the extroardinary expedient of super-low interest rates.

After all, when you see a person in the hospital with oxygen tubes in her nose and a saline drip in her arm, you assume the doctors have done this for some good reason. Most likely, if the tubes were removed the patient's health would be in serious jeopardy. But all else being equal, having tubes stuck in you is a pretty crappy situation. It's uncomfortable, and it limits your mobility. As soon as it's safe, you'd want to pull the tubes out. Now that the emergency created by the 2008 financial crisis is over, some people are anxious to pull the tube out and let the patient get back to living a normal life.

But there's actually no reason to think low interest rates are a problem for the US economy. Low interest rates reduce the federal deficit, encourage entrepreneurship, and boost economic growth. As long as inflation stays low — and right now, it's extremely low and likely to stay that way for a long time — we should relax and enjoy the benefits.

The perverse urge to normalize

Back in early August, the conventional wisdom was that the Federal Reserve would finally raise interest rates for the first time since house prices started to collapse more than seven years ago. Then the financial trauma coming out of Asia cast doubt on that. William Dudley, the influential president of the New York Fed, said recent events made a rate hike "less compelling," and, partly as a result, US markets have been soaring ever since.

But Dudley also said, "I really do hope we can raise interest rates this year," and, most of all, that there's no reason to be thinking about new efforts at monetary stimulus: "I’m a long way from quantitative easing. The US economy is performing quite well."

This central analytic mistake is repeated daily on financial television shows, on "finance Twitter," in the business press, and apparently in staff-level discussions in the Federal Reserve. The conceit is that raising interest rates is a good thing, and the Fed should do it as soon as possible. Debate is entirely focused on whether higher rates would be catastrophic. Any good economic news counts as a reason to think they wouldn't be and therefore should come sooner.

In order to make it seem more obvious that higher interest rates are good, proponents of higher interest rates have taken to calling higher interest rates "normalizing" monetary policy. Normal things are good, right? Who could be against normal?

The case for low interest rates

But this is both totally wrong and a remarkably recent idea.

Back in the 1990s, the Clinton administration wanted to reduce the budget deficit because they perceived that a lower deficit would lead to lower interest rates, which would bring a positive impact to the economy. Back in 2009 when the Great Recession and the Obama stimulus were making the deficit very big, critics warned (wrongly) that "bond vigilantes" would wreck the US economy by bringing higher interest rates.

People knew, in other words, that all else being equal, low interest rates are good. Let me count the ways:

  • Low rates make it easier for younger and more cash-strapped people to buy houses, cars, and other durable goods.
  • Increased demand for durable goods creates more employment opportunities for building and installing those goods.
  • Low rates reduce the need for the federal government to increase taxes or reduce spending.
  • Low rates make it easier for state and local governments to make physical infrastructure investments with long-term payoffs.
  • Low rates mean that people with money who are hoping to earn a decent return need to seek out more adventurous investment opportunities, making it much easier for innovators and entrepreneurs to obtain funding.

The last point is worth dwelling on. Many people see the relationship between low interest rates and high-tech investments and say that they see a "bubble." The relationship is real, but this is not what a bubble is. Low interest rates are part of the fundamentals of the American economy, and have been for years now. One thing that happens in an economy that has low interest rates is that money flows into the hands of entrepreneurs and innovators rather than being tied up exclusively in financing government debts and plain vanilla mortgages. Having an economy that is friendly to entrepreneurs and innovators is good. It's a reason to hope interest rates stay low.

Inflation is very low

Of course, just because low interest rates are good doesn't mean that you should never raise rates. A central bank that's determined to keep rates low forever regardless of what happens would eventually overheat the economy and produce troubling levels of inflation.

But the United States does not currently have an inflation problem:

  • Inflation has run below the Fed's 2 percent target for several years now.
  • Inflation is currently falling, due to falling global commodity prices and a rising US dollar.
  • Market-based expectations of inflation indicate that people do not think inflation will go above the 2 percent target on a consistent basis for more than 10 years.

There is an interesting academic question of how much more the US economy can grow before an inflation problem emerges. My view is that it could probably grow quite a bit, but any honest person has to admit there's a lot of uncertainty here. The clearer issue is that there's little risk in trying to find out and considerable benefit to keeping rates as low as possible for as long as possible.

Bold central banking is a boon to the marginalized

At a recent congressional hearing, Fed Chair Janet Yellen was asked about the black-white unemployment gap and said basically that there's nothing she can do about it. If you delve into the data, it's easy enough to see what she means — the African-American unemployment rate and the white unemployment rate move in tandem, at a 2-to-1 ratio that seems to be fixed by factors that are out of control of monetary policy.

But as Jared Bernstein points out, this semi-fixed ratio actually means that monetary policy matters a great deal for the racial gap. If white unemployment goes from 10 percent to 5 percent, the Fed has achieved a 5 percentage point reduction. At the same time, we would expect black unemployment to fall from 20 percent to 10 percent — a much larger 10 percentage point reduction.

With the United States currently enjoying a lowish 5.5 percent unemployment rate, it's easy for relatively privileged people to neglect the benefits of further small reductions. But for an African-American population that will enjoy a double-scale version of any drop in the unemployment rate, the stakes remain quite high.

The same is true of other kinds of vulnerable populations. The college-educated cohort that dominates discussion of economic policy already has a very low unemployment rate. But working-class Americans could see considerable benefit from a stronger labor market.

A real return to normal

What the Fed needs to do is redefine its conception of normalizing policy. Normal monetary policy is pretty simple — higher interest rates when needed to fight inflation, but not otherwise.

That's what normal monetary policy looks like. It's true that slowing population growth, aging, higher levels of foreign savings, and other factors seem to be systematically pushing interest rates to a level below what's historically normal. But it's also true that the US population is older and slower-growing than what's historically normal, which is true of other wealthy countries as well. Things change over time. What shouldn't change is the basic philosophy that tighter money is a solution to a specific problem — economic overheating — not a goal to be pursued at the soonest possible moment.

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