The Divergent View’s Response to Ben Bernanke’s Blog on “Why Are Interest Rates So Low?”

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In his first blog post, former chairman of the Federal Reserve, Ben Bernanke, attempts to silence Fed critics by answering the following question, “Why are interest rates so low?”  Read his blog post here.

Bernanke makes the following points in his article: 1) the equilibrium real interest rate is low during weak economic times and high during strong economic times, 2) savers are better off in the long run by having held interest rates low since a premature rate increase would have pushed the economy back into recession, thus reducing returns on capital investment, and 3) the Fed did not artificially keep interest rates too low because the equilibrium rate is very low anyways.

Below, I will explain why I disagree with almost everything said in Ben Bernanke’s post.

Equilibrium Real Interest Rates (RIR) – Part of Academia, not the Real World

In his post, Bernanke contests that “Many factors affect the equilibrium rate, which can and does change over time. In a rapidly growing, dynamic economy, we would expect the equilibrium interest rate to be high, all else equal, reflecting the high prospective return on capital investments. In a slowly growing or recessionary economy, the equilibrium real rate is likely to be low, since investment opportunities are limited and relatively unprofitable.”  Bernanke goes on to say that keeping rates below the equilibrium rate eventually leads to overheating of the economy and inflation, whereas keeping rates above the equilibrium rate would slow the economy and tip in into recession.

By asserting that the equilibrium RIR was already very low to begin with in the years after the 2008 financial crisis, Bernanke makes the justification that zero interest rates were appropriate since the weak economy was setting an equilibrium RIR that was very low anyways.

However, let’s discuss equilibrium RIR some more.  First, equilibrium rates are purely theoretical and not directly observable in any data.  In a 2010 study, Alejandro Justiniano, a Chicago Fed economist, and Giorgio E. Primiceri, a Northwestern University economics professor, published a paper where they attempt to measure the historical equilibrium RIR.  The complexity of the formula used to estimate the equilibrium RIR is astonishing and simply incomprehensible to 99.99% of the population, myself included.  So instead of attempting to pick holes in their methodology used, I present below their theoretical result for the equilibrium RIR (smoothed blue line).

Equilibrium RIR

Their results show that in good economic years, the equilibrium RIR is high, and in bad economic years, the RIR is low.  In fact, they show that there have been at least three occasions since the 1960s when the RIR went negative with two of those instances occurring post the 2000 Internet bubble crash and post the 2008 financial crisis.  Their latest data point in the chart above shows an equilibrium RIR of around negative 2%.

However, these results simply do not pass the common sense test.  Intuitively, it does make some sense that equilibrium rates would go down during a slow economy and up during a good economy.  At the end of the day, interest rates are simply the price of money, which is governed by supply and demand factors.  It makes sense that during good economic times, a car manufacturer, for example, may push prices higher as demand for the product increases.  It makes sense that during bad economic times, that same car manufacturer may lower prices as demand for that car weakens.  However, no car manufacturer in the world would ever sustainably sell cars for negative profit no matter how bad the economy was.

But yet, the results of this study show that lenders would be willing to lose money on loans during hard economic times.  Although some banks and investors in Europe have very recently bought government debt with small negative interest rates, I believe this is more speculative, front-running of ECB quantitative easing vs. a true desire to lose money on an investment.  Aside from this isolated incident, I find it very hard to believe that we can ever be in a situation where lenders would be willing to pay borrowers to loan them money.  And if is possible, why haven’t we heard of more instances of LIBOR – 300 bps?

Bernanke and the Fed believed that the equilibrium RIR went negative after 2008, and this was used as justification for bringing short-term and long-term rates as low as possible to close the gap to a negative RIR.  However, how do we really know the equilibrium RIR was negative?  What if the equilibrium RIR was actually 0% or 1% or 2%?  This would create massively different implications for monetary policy.

So to go back to the original question, “Why are interest rates so low?”  Bernanke believes it is because the equilibrium RIR is “probably negative.”  I believe that the equilibrium RIR estimated in Fed models is probably too low.  So a more likely and just as credible answer to this question is that the Fed has based interest rate policy on an equilibrium RIR that has potentially been estimated incorrectly.

Retirees – Not Better Off Due to Low Rates

Later in the blog post, Bernanke says, “the legislators were concerned about retirees living off their savings and able to obtain only very low rates of return on those savings.  I was concerned about those seniors as well.  But if the goal was for retirees to enjoy sustainably higher real returns, then the Fed’s raising interest rates prematurely would have been exactly the wrong thing to do…A premature increase in interest rates engineered by the Fed would therefore have likely led after a short time to an economic slowdown and, consequently, lower returns on capital investments.”

For a retiree aged 65, the average life expectancy is around 18 years for men.  We have now had zero interest rate policy for coming up on 7 years, and based on the gradual rate increase path suggested by the Yellen Fed, it may take another 2-3 years to even get close to normalized rates.

This means for the average senior, well more than half of their remaining years have been spent worrying about how to generate income from their savings.  If the Fed’s measure of success was asking retirees to give up 10 years of income, so that they can enjoy their remaining 8 years with “sustainably higher returns,” then, I think the Fed missed the mark on this issue.

The Fed Has Indeed Kept Rates Artificially Low

Finally, Bernanke concludes that, “A similarly confused criticism often heard is that the Fed is somehow distorting financial markets and investment decisions by keeping interest rates ‘artificially low.’ Contrary to what sometimes seems to be alleged, the Fed cannot somehow withdraw and leave interest rates to be determined by ‘the markets.’ The Fed’s actions determine the money supply and thus short-term interest rates; it has no choice but to set the short-term interest rate somewhere. So where should that be? The best strategy for the Fed I can think of is to set rates at a level consistent with the healthy operation of the economy over the medium term, that is, at the (today, low) equilibrium rate. There is absolutely nothing artificial about that!”

By definition, if a government agency set the price for any good, whether that good is a car, computer, or interest rate, it would be considered an artificial rate.  But since interest rate setting by the Federal Reserve is unlikely to change, the real issue is not whether the rate is artificial, but whether or not the interest rate is artificially low.  As I’ve discussed above about the equilibrium RIR, if the Federal Reserve incorrectly estimated this rate to be too low, then, by consequence, the Fed has indeed kept rates at an artificially low level.

Bernanke asserts that the Fed has not distorted financial markets and investment decisions by refuting the notion that rates are artificially low.  Any casual observer or investor in the financial markets knows this to be categorically untrue.  Traders aggressively buy equities at the parsing of every dovish word of the Federal Reserve.  Good economic news frequently cause the markets to trade down as traders expect the Federal Reserve to raise rates sooner.  Bad economic news cause the markets to trade up as traders expect a later rate increase.  Investment decisions are frequently being made based on the actions of the Federal Reserve rather than underlying company profits or economic fundamentals.  Housing prices have skyrocketed due to low rates, and in many parts of the country, home prices exceed 2007 peaks.  If the economy is actually weak and thus has a low equilibrium RIR according to Bernanke’s logic, then, how is it possible that home prices are surging during this supposedly weak economy?

The bottom line is that the Fed has in fact distorted financial markets by boosting asset prices with little to show for the real economy.  But don’t just take my word for it:

Alan Greenspan:

“There have been two aspects to quantitative easing.  One is to galvanize effective demand by creating credit in the marketplace.  That has not worked.  But what has worked is the second prong of the issue that originated quantitative easing…getting the real rate of return on long-term assets down, and that will have a major effect on price/earnings ratios, on cap ratios in real estate, on all income earning assets.  And indeed, in that respect, it’s been a terrific success, but it hasn’t been a success on the demand side…”