At their September meeting, the Federal Reserve decided, for the 54th consecutive time, to leave short-term interest rates unchanged at a near-zero level. While only one voting member of the Federal Open Market Committee (FOMC) dissented, the Fed’s action, or rather inaction, was hotly debated.
Those advocating an immediate hike argued that the economy had progressed far beyond the emergency conditions that had led to the imposition of a zero interest rate policy in the first place and that the Fed was already dangerously “behind the curve.” Those lobbying for further delay pointed to a lack of wage inflation and signs of weakness in the global economy.
However, frustratingly, we believe this argument, like all monetary policy debates in recent years, has been waged on a false premise, namely that increasing short-term interest rates, even from these extraordinarily low levels, would hurt aggregate demand. We believe that the opposite is true. The real-world relationship between interest rates and aggregate demand is non-linear and an examination of the transmission mechanisms suggest that the first few rate hikes, far from depressing aggregate demand, would actually boost it.
Raising short-term interest rates from very low levels could actually increase aggregate demand
There is, of course, more to the story. All of these effects have changed over the decades so that this argument might not have been as strong had a zero interest rate policy been employed, say, in the 1960s. In addition, the impact of interest rates on the economy is asymmetric — a cut in interest rates from a normal level that had been sustained for some time might well boost demand even if an increase to that level didn’t dampen it. Finally, on the supply side, there is likely a significant long-term cost in lost economic efficiency from holding the price of money at an artificially low level. All of these issues are worth further research. However, for the Federal Reserve, the basic point is the most important one. The reason it should have raised rates in September and the reason, failing that, that it should do so this month isn’t that the economy can handle the pain but rather that it could do with the help.