UPDATE: Fed Fisher: expansionary fiscal policy could lift natural rate

(Updated - October 17, 2016 12:17 PM EDT)

Fed Fisher: expansionary fiscal policy could lift natural rate. Aging, investment holding back rates.

Prepared Speech:

Vice Chairman Stanley Fischer
At the Economic Club of New York, New York, New York
October 17, 2016

Why Are Interest Rates So Low? Causes and Implications

I am grateful to the Economic Club of New York for inviting me to speak today. My subject is the historically low level of interest rates, a topic not far from the minds of many in this audience and of many others in the United States and all over the world.1

Notwithstanding the increase in the federal funds rate last December, the federal funds rate remains at a very low level. Policy rates of many other major central banks are lower still--even negative in some cases, even in countries long famous for their conservative monetary policies. Long-term interest rates in many countries are also remarkably low, suggesting that participants in financial markets expect policy rates to remain depressed for years to come. My main objective today will be to present a quantitative assessment of some possible factors behind low interest rates--and also of factors that could contribute to higher interest rates in the future.

Now, I am sure that the reaction of many of you may be, "Well, if you and your Fed colleagues dislike low interest rates, why not just go ahead and raise them? You are the Federal Reserve, after all." One of my goals today is to convince you that it is not that simple, and that changes in factors over which the Federal Reserve has little influence--such as technological innovation and demographics--are important factors contributing to both short- and long-term interest rates being so low at present.

There are at least three reasons why we should be concerned about such low interest rates. First, and most worrying, is the possibility that low long-term interest rates are a signal that the economy's long-run growth prospects are dim. Later, I will go into more detail on the link between economic growth and interest rates. One theme that will emerge is that depressed long-term growth prospects put sustained downward pressure on interest rates. To the extent that low long-term interest rates tell us that the outlook for economic growth is poor, all of us should be very concerned, for--as we all know--economic growth lies at the heart of our nation's, and the world's, future prosperity.

A second concern is that low interest rates make the economy more vulnerable to adverse shocks that can put it in a recession. That is the problem of what used to be called thezero lower bound on interest rates. In light of several countries currently operating with negative interest rates, we now refer not to the zero lower bound, but to the effective lower bound, a number that is close to zero but negative. Operating close to the effective lower bound limits the room for central banks to combat recessions using their conventional interest rate tool--that is, by cutting the policy interest rate. And while unconventional monetary policies--such as asset purchases, balance sheet policies, and forward guidance--can provide additional accommodation, it is reasonable to think these alternatives are not perfect substitutes for conventional policy. The limitation on monetary policy imposed by low trend interest rates could therefore lead to longer and deeper recessions when the economy is hit by negative shocks.

And the third concern is that low interest rates may also threaten financial stability as some investors reach for yield and compressed net interest margins make it harder for some financial institutions to build up capital buffers. I should say that while this is a reason for concern and bears continual monitoring, the evidence so far does not suggest a heightened threat of financial instability in the post-financial-crisis United States stemming from ultralow interest rates. However, I note that a year ago the Fed did issue warnings--successful warnings--about the dangers of excessive leveraged lending, and concerns about financial stability are clearly on the minds of some members of the Federal Open Market Committee, FOMC.

Those are three powerful reasons to prefer interest rates that are higher than current rates. But, of course, Fed interest rates are kept very low at the moment because of the need to maintain aggregate demand at levels that will support the attainment of our dual policy goals of maximum sustainable employment and price stability, defined as the rate of inflation in the price level of personal consumption expenditures (or PCE) being at our target level of 2 percent.

That the actual federal funds rate has to be so low for the Fed to meet its objectives suggests that the equilibrium interest rate--that is, the federal funds rate that will prevail in the longer run, once cyclical and other transitory factors have played out--has fallen.2 Let me turn now to my main focus, namely an assessment of why the equilibrium interest rate is so low.

To frame this discussion, it is useful to think about the real interest rate as the price that equilibrates the economy's supply of saving with the economy's demand for investment. To explain why interest rates are low, we look for factors that are boosting saving, depressing investment, or both.3 For those of you lucky enough to remember the economics you learned many years ago, we are looking at a point that is on the IS curve--the investment-equals-saving curve. And because we are considering the long-run equilibrium interest rate, we are looking at the interest rate that equilibrates investment and saving when the economy is at full employment, as it is assumed to be in the long run.

I will look at four major forces that have affected the balance between saving and investment in recent years and then consider some that may be amenable to the influence of economic policy.

The economy's growth prospects must be at the top of the list. Among the factors affecting economic growth, gains in productivity and growth of the labor force are particularly important. Second, an increase in the average age of the population is likely pushing up household saving in the U.S. economy. Third, investment has been weak in recent years, especially given the low levels of interest rates. Fourth and finally, developments abroad, notably a slowing in the trend pace of foreign economic growth, may be affecting U.S. interest rates.

To assess the empirical importance of these factors in explaining low long-run equilibrium interest rates, I will rely heavily on simulations that the Board of Governors' staff have run with one of our main econometric models, the FRB/US model. This model, which is used extensively in policy analyses at the Fed, has many advantages, including its firm empirical grounding, and the fact that it is detailed enough to make it possible to consider a wide range of factors within its structure.

Going through the four major forces I just mentioned, I will look first at the effect that slower trend economic growth, both on account of the decline in productivity growth as well as lower labor force growth, may be having on interest rates. Starting with productivity, gains in labor productivity have been meager in recent years. One broad measure of business-sector productivity has risen only 1-1/4 percent per year over the past 10 years in the United States and only 1/2 percent, on average, over the past 5 years. By contrast, over the 30 years from 1976 to 2005, productivity rose a bit more than 2 percent per year. Although the jury is still out on what is behind the latest slowdown in productivity gains, prominent scholars such as Robert Gordon and John Fernald suggest that smaller increases in productivity are the result of a slowdown in innovation that is likely to persist for some time.4

Lower long-run trend productivity growth, and thus lower trend output growth, affects the balance between saving and investment through a variety of channels. A slower pace of innovation means that there will be fewer profitable opportunities in which to invest, which will tend to push down investment demand. Lower productivity growth also reduces the future income prospects of households, lowering their consumption spending today and boosting their demand for savings. Thus, slower productivity growth implies both lower investment and higher savings, both of which tend to push down interest rates.5

In addition to a slower pace of innovation, it is also likely that demographic changes will weigh on U.S. economic growth in the years ahead, as they have in the recent past. In particular, a rising fraction of the population is entering retirement. According to some estimates, the effects of this population aging will trim about 1/4 percentage point from labor force growth in coming years.6

Lower trend increases in productivity and slower labor force growth imply lower overall economic growth in the years ahead. This view is consistent with the most recent Summary of Economic Projections of the FOMC, in which the median value for the rate of growth in real gross domestic product (GDP) in the longer run is just 1-3/4 percent, compared with an average growth rate from 1990 to 2005 of around 3 percent.7

We can use simulations of the FRB/US model to infer the consequences of such a slowdown in longer-run GDP growth for the equilibrium federal funds rate. Those simulations suggest that the slowdown to the 1-3/4 percent pace anticipated in the Summary of Economic Projections would eventually trim about 120 basis points from the longer-run equilibrium federal funds rate.8

Let me move now to the second major development on my list. In addition to its effects on labor force growth, the aging of the population is likely to boost aggregate household saving. This increase is because the ranks of those approaching retirement in the United States (and in other advanced economies) are growing, and that group typically has above-average saving rates.9 One recent study by Federal Reserve economists suggests that population aging--through its effects on saving--could be pushing down the longer-run equilibrium federal funds rate relative to its level in the 1980s by as much as 75 basis points.10

In addition to slower growth and demographic changes, a third factor that may be pushing down interest rates in the United States is weak investment. Analysis with the FRB/US model suggests that, given how low interest rates have been in recent years, investment should have been considerably higher in the past couple of years. According to the model, this shortfall in investment has depressed the long-run equilibrium federal funds rate by about 60 basis points.

Investment may be low for a number of reasons. One is that greater perceived uncertainty could also make firms more hesitant to invest. Another possibility is that the economy is simply less capital intensive than it was in earlier decades.11

Fourth on my list are developments abroad: Many of the factors depressing U.S. interest rates have also been working to lower foreign interest rates. To take just one example, many advanced foreign economies face a slowdown in longer-term growth prospects that is similar to that in the United States, with similar implications for equilibrium interest rates in the longer run. In the FRB/US model, lower interest rates abroad put upward pressure on the foreign exchange value of the dollar and thus lower net exports. FRB/US simulations suggest that a reduction in the equilibrium federal funds rate of about 30 basis points would be required to offset the effects in the United States of a reduction in foreign growth prospects similar to what we have seen in the United States.

The first figure shows the effects of these four factors. You will see that each factor is considered separately; there is no attempt to add them together. That is because the broad factors we are considering here could well overlap--particularly the link between slower growth and the remaining three factors. Still, the comparison gives us a notion of the relative importance of some of the leading explanations for the decline in interest rates.

I started by noting the costs of low interest rates, including the limits on the ability of monetary policy to respond to recessions, and possible risks to financial stability. Now that we have some notion of where lower interest rates might be coming from, I want to turn to the question of what might contribute to raising longer-run equilibrium interest rates.12

One development that would boost the equilibrium interest rate would be a further waning in the investor precaution that seems to have been holding back investment--in Keynesian terms, an improvement in animal spirits. The first bar in the second slide illustrates the effects on the longer-run equilibrium federal funds rate of an increase in business-sector investment equal to 1 percent of GDP. As can be seen, such a rebound in investment would raise the equilibrium funds rate by 30 basis points, according to the FRB/US model. In addition, higher investment would improve the longer-run growth prospects of the U.S. economy, although the effects in this particular case are fairly small, with real GDP growth about 0.1 percentage point higher on account of the higher investment.

Over the years, many economists--some of them textbook authors--have noted that expansionary fiscal policy could raise equilibrium interest rates.13 To illustrate this possibility, the next two bars on the slide show the estimated effect on interest rates of two possible expansionary fiscal policies, one that boosts government spending by 1 percent of GDP and another that cuts taxes by a similar amount. According to the FRB/US model, both policies, if sustained, would lead to a substantial increase in the equilibrium federal funds rate. Higher spending of this amount would raise equilibrium interest rates by about 50 basis points; lower taxes would raise equilibrium rates by 40 basis points. I should note that the FRB/US model does not contain a great deal of detail about taxes and government spending. These are thus the effects of very broad changes in income taxes and government spending, and not those of any specific, detailed, policy measures.

It is important to emphasize that these estimates are from just one model and other models may give different results. Still, I think these implications of fiscal policy measures are qualitatively correct--they are a standard result in many models, including the simplest textbook IS-LM model.

Stimulative fiscal policies such as these could be beneficial if the economy confronted a recession. Of course, it would be important to ensure that any fiscal policy changes during a recession did not compromise long-run fiscal sustainability.

Government policies that boost the economy's long-run growth rate would be an even better means of raising the equilibrium interest rate. This is a point I have also made in the past.14 While there is disagreement about what the most effective policies would be, some combination of more encouragement for private investment, improved public infrastructure, better education, and more effective regulation is likely to promote faster growth of productivity and living standards--and also to reduce the probability that the economy and, particularly, the central bank will in the future have to contend with the effective lower bound.

In summary, a variety of factors have been holding down interest rates and may continue to do so for some time. But economic policy can help offset the forces driving down longer-run equilibrium interest rates. Some of these policies may also help boost the economy's growth potential.

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