Over the past few years, both real and nominal interest rates have fallen to unusually low levels. In the United States, risk-free interest rates are still well below 1 percent, even during the eighth year of an economic expansion. Japan and much of Western Europe are currently experiencing negative interest rates. This fact raises two questions: What is causing those low rates, and what would it take to move interest rates up to a more “normal” level? Although I will focus on the second question, doing so will indirectly address the first.
One common mistake is to discuss the impact of higher interest rates without first explaining how the increase occurs. I call this “reasoning from a price change.” It would be like discussing the impact of high oil prices on oil consumption without first establishing whether the oil price increase was caused by rising demand or decreased supply.
To avoid this problem, I’ll discuss four different ways that government policymakers could attempt to push interest rates higher:
- A contractionary monetary policy
- An expansionary monetary policy
- An expansionary fiscal policy
- Supply-side reforms
Contractionary Monetary Policy
When people discuss a hypothetical increase in interest rates, they usually have in mind the first option, a contractionary monetary policy. In this view, the Federal Reserve has a magic wand of sorts and can set interest rates wherever it likes. Of course, there has to be some truth to this claim, or it would not be so widely held. The Fed is able to influence short-term interest rates through the so-called liquidity effect. Thus, a reduction in the money supply will tend to push interest rates up in the short term.
However, the liquidity effect is much weaker than most people assume. In a relatively short period of time, a contractionary monetary policy will set in motion forces that actually put downward pressure on nominal interest rates. For instance, a tight money policy will tend to reduce the expected rate of inflation and reduce the expected rate of growth in real GDP. Both of those effects tend to reduce nominal interest rates, the first through the so-called Fisher effect: the tendency of interest rates to rise and fall with changes in the expected rate of inflation. In addition, lower expected real GDP growth tends to depress real interest rates as it reduces the demand for credit to finance new investment projects. Both effects, then, tend to reduce nominal interest rates.
A good example of this phenomenon occurred recently in Europe. In 2011, the European Central Bank (ECB) twice raised short-term interest rates with a contractionary monetary policy. In the long run, however, that policy led to much slower growth in nominal GDP, which pushed interest rates much lower than in early 2011. Today, Europe has lower interest rates than the United States precisely because the ECB tried to raise interest rates prematurely in 2011 and caused a double-dip recession. Similar mistakes were made by the Bank of Japan in 2000 and 2006, when small interest rate increases pushed Japan back into deflation.
Expansionary Monetary Policy
A more durable way to raise interest rates above zero would be to increase the inflation or nominal GDP growth rate target. An expansionary monetary policy would lead to faster real GDP growth in the short run and to a higher expected inflation rate in the long run. Consider the case of Australia, which never hit the zero interest rate boundary. That central bank has a more expansionary monetary policy than most other developed countries, and hence Australia has a higher nominal GDP growth rate, which keeps its nominal interest rates above zero.
Although expansionary monetary policy does push interest rates higher in the long run, it does so by raising the expected rate of inflation. Hence, the real interest rate may not increase, which means that savers would be no better off than they are today. To provide a durable increase in real interest rates, the United States needs to look beyond monetary policy.
Expansionary Fiscal Policy
Keynesian economists often advocate fiscal stimulus as a way of boosting the economy. Deficit spending can result in higher interest rates, both real and nominal, as increased government borrowing raises the demand for credit. In my view, however, this effect is relatively weak. Over the past few decades, Japan has seen its national debt soar to nearly 250 percent of GDP, and yet interest rates remain close to zero. Thus, the government needs to look beyond monetary and fiscal policy if it hopes to raise real interest rates on a consistent basis.
Supply-side policy reforms may offer the best chance of achieving higher real interest rates. Consider the case of Australia. The primary reason Australia’s interest rates have generally been higher than those in other developed countries is that its real GDP growth rate is well above average for a developed country.
It’s useful to break the overall growth rate down into two components: population growth and growth in output per capita. Australia has a higher rate of population growth than most other developed countries, primarily as a result of its much higher rate of immigration.
The single most effective policy reform for raising the trend rate of growth in real GDP would be to increase the rate of immigration, particularly the immigration of skilled workers. Employment can also be boosted by various labor market reforms, which would tend to increase the labor force participation rate. Reductions in marginal income tax rates, as well as replacement of welfare programs with work-enhancing alternatives such as the Earned Income Tax Credit, could help to boost the number of hours worked.
The productivity of workers can be boosted by a wide range of policy reforms. Liberalizing zoning and other land-use restrictions would allow more growth in high-productivity areas such as Silicon Valley. Tax reform that reduces the tax rate on capital income would help to boost savings and investment. Other regulatory reforms in areas such as occupational licensing and intellectual property rights could also raise productivity.
To summarize, higher nominal interest rates require an increase in the real interest rate, in the expected rate of inflation, or in both. A more expansionary monetary policy is the only reliable way to boost inflation expectations in the long run. There’s no single magic bullet for increasing real interest rates, but—in my view—a wide range of supply-side reforms provides the best chance of success.