Making the Interest Rate Interesting

By / 1.6.2010

As we head into the new year, one of the biggest questions facing the economy is: “Whither the interest rate?” This number is set by the Federal Open Market Committee and its targeting of the fed funds rate – or the rate at which banks lend funds to each other – is currently effectively zero (technically in a range from zero to 0.25 percent). It’s been there for just over a year, and is likely going to stay there for the better part of 2010 (if I could tell you when, I wouldn’t be here – I’d be lighting cigars with hundred-dollar bills some place much warmer).

Despite its provenance as a dry economic term, the interest rate is interesting. It’s a fundamental piece of how our economy works. It determines everything, from how likely you are to get a loan or a mortgage (ceteris paribus – as the economists like to say – the lower the rate, the more lending that is done), to how likely we’re going to have inflation (high interest rates head off inflation, ceteris paribus), to how much a dollar is worth (a higher interest rate relative to overseas rates means it’ll be worth more, cete- you get the idea), to how fast the economy will grow (higher interest rates mean slower growth). It is usually the most powerful tool in any central banker’s toolbox, and certainly the one that’s most often used.

In addition to its central role in the economy, the interest rate is interesting for two other reasons these days.

First, there is the discussion of where the interest rate should be for recovery. There’s a good rule of thumb to determine what the ideal interest rate is: the Taylor rule. Very briefly put, the Taylor rule takes the inflation rate and the unemployment rate and uses them to compute what the ideal interest rate should be (check out the San Francisco Fed for more info). According to some Fed research last spring, the Taylor rule says that interest rates should be at -5 percent (that’s negative five percent – as unemployment is 1.5 percent higher now, the Taylor rule would say the rate now should be even lower).

The problem with negative interest rates is that while they’re technically feasible, they really discourage lending (would you give me a dollar today if I promised you ninety cents next Tuesday?). More realistically, negative real interest rates are possible if you encourage inflation. But inflation eats away at economic growth – ask Zimbabwe – and the “inflation tax” of high inflation falls disproportionately on the poor.

But inflation hawks have been arguing for the Fed to raise rates for a couple of months – to two percent. These hawks tend to be strongly laisse faire conservatives, One of the voices saying we should ignore the Taylor rule is – as Brad DeLong points out – the man who invented it himself, Stanford University’s (and Bush Treasury appointee) John Taylor.

Secondly, as the old saying goes: when the only tool you have is a hammer, every problem begins to look like a nail. Interest rates, while powerful, cannot solve every economic problem. The Taylor rule tells us we shouldn’t raise the interest rate, we can’t lower the interest rate, and no one is happy where the economy is now. At a time when the interest rate is at zero, and should be negative, alternatives need to be explored. As Clive Crook says in his latest column:

Interest rates that take into account asset prices as well as general inflation are part of this, of course. But when it comes to financial regulation, the key thing is rules that recognise the credit cycle, and change as it proceeds. Most important, as argued by Charles Goodhart in these pages, capital and liquidity requirements should be time-varying and strongly anti-cyclical. In good times, when lending is expanding quickly and financial institutions’ concerns about capital and liquidity are at their least, the requirements should tighten. Under current rules, they do the opposite.

Crook is right that unusually low capital ratios (and their counterparts – high leverage ratios) were a catalyst of last year’s crisis. Now that we need to get the economy going again, banks need to lend. One way to do so would be to lower capital ratios (if it wouldn’t bring the solvency of some large banks into question). As part of a regulatory reform package, policymakers should pursue a counter-cyclical capital requirements policy.

They should also expand who has to follow capital requirements. As currently defined, only depository institutions and not investment banks – such as Lehman Brothers and Merrill Lynch were, and Goldman Sachs and Morgan Stanley used to be – are required to follow the Fed’s Board of Governor’s capital requirements. Getting other financial institutions to respond to capital requirements will make that a much more powerful tool.