Commentary: Interest rates are low because of government policy

John Williams, president of the San Fransisco Fed has made news today by sharing some controversial views on interest rates.  Williams is concerned that low long term interest rates gives monetary policy less room to maneuver during recessions.  Williams advocates raising the Fed's inflation target, and for more proactive fiscal policy.  

The press's coverage of Williams' comments has been confused over what he means by 'interest rate.'  Within Fed and monetary policy circles, the idea of a 'natural rate of interest,' a central bank policy rate rate which allows for full employment but does not result in above target inflation still holds much sway.  This is distinct from market rates of interest which are allowed to float freely, such as the ten year Treasury note yield. 

Operationally of course, there is nothing 'natural' about any central bank policy rate, because the monetary authority either remunerates reserve balances to set an interest rate floor, or actively drains and adds liquidity to the financial sector via open market operations to hit rate targets.  A central bank could also abandon interest rate targets altogether and supply a fixed amount of reserve balances. This would allow short term rates to be determined by market forces.  The Fed did this from 1979 until 1982.  

When thinking about the idea of a 'natural policy rate of interest' it is important to remember how policy rates affect the real economy.  The cost (accounting or opportunity) for a bank to fund a loan is the geometric average of the central bank policy rates over the life of the loan.  Banks, which must make a profit for shareholders, will charge borrowers a fixed rate of interest which exceeds the expected average policy rate.  A cut in the policy rate today, or the signalling of rate cuts to come in the near future will reduce the expected average rate.  This represents a cost savings for the banks, and if lending markets are competitive, results in lower rates for bank loans.  All else being equal, lower interest rates results in more credit creation, a larger money supply, and a higher price level. 

The rub is that the above story is predicated on a public which is willing and able to borrow.  Williams' claims that the natural rate of interest has fallen because of an aging population.  In other words, since older people borrow less often, even lower rates of interest would be required to induce public to take bank loans and transmit monetary policy across the economy.  In other words, the Fed can set policy rates well below historical averages without causing inflation because of a secular decline in the demand for credit. 

Press coverage has unfortunately largely conflated the 'natural policy rate of interest' and its potential decline with the sharp fall in government bond yields.  The back up in yields of US Treasurys over the past year is the result of government policy.  The four rate hikes that the market was expecting in 2016 and the Fed was signalling last year have not and will not materialize.  At the same time, the US Treasury has significantly boosted the issuance of securities with tenors less than two years.  This is has increased the supply of short term bills relative to long term bonds, and has helped flatten the yield curve.  Of course, nothing stops the US Treasury from issuing more long term debt.  This would require higher bond yields in order for the bond market to clear, resulting in higher lending rates across the entire economy.  

In sum, the government still controls interest rates, and rates are lower today because of government policy.  What a prudent path for policy might be in the future, or what is the 'natural policy rate' is an interesting question and Williams has contributed to the economic discourse just by sparking a debate.