The Cost Of a Low Neutral Rate Of Interest

The retiring president of the Minneapolis Federal Reserve provides an excellent analysis of the effects of a low neutral interest rate, and the pros and cons of raising the neutral rate.  The neutral rate is defined as the rate of interest consistent with the Fed's mandated goals of full employment and its 2% inflation target.  The neutral has been falling in recent years and it creates two kinds of problems.  In the first place, it reduces the effectiveness of traditional monetary policy when nominal interest rates are close to the zero lower bound.  The Fed has resorted to the use of extraordinary policies which have their own strengths and weaknesses which are well described in this article.  Secondarily, low interest rates on safe assets, issued by the Treasury, encourage investors to seek higher yields on riskier assets.  This increases the risk of financial instability.  Our recent financial crisis provides a good example of what can happen when investors seek higher returns on riskier assets.

The government can increase the neutral rate of interest by issuing more securities and increasing its level of debt.  If we are agnostic about the effectiveness  to which the new debt is used by government, we have to consider the welfare effects of a higher debt burden.  That issue is well described in this article.  There will be winners and losers from this policy.  Elected officials who are responsible for fiscal policy must make those decisions. Paul Krugman provides many examples of how our politicians think about government debt. He is not very hopeful.  Krugman is not agnostic about how government might use the new debt that it creates.  He suggests lots of good investments might be made at very low cost.  Most of our politicians have more expertise, and concern, about running for office than they have about the development of effective fiscal policy.  They feed the public what it likes to hear.