Don’t blame central bankers for persistently low interest rates

Many who are supportive of free markets blame central banks for the low interest rates that have prevailed since the end of the 2007-8 financial crisis.  This is a mistake.

Central banks can, in the short run and all else being equal, lower market interest rates through expansionary open market operations.  But this ‘liquidity effect’ is temporary.  All else being equal, expansionary OMO will result in higher real income, and hence higher demand for capital.  This puts upward pressure on market interest rates.  Also, expansionary monetary policy eventually creates inflation, the expectation of which market actors in capital markets will factor into their contracts.  This also tends to increase market interest rates.  Ultimately, monetary authorities have some control over interest rates in the short run, but almost no control in the long run.

(This assumes OMO is still the primary means of conducting monetary policy.  If central banks decide to use the corridor between the discount rate and interest paid on reserves as a policy tool, then we’ve got something to talk about.  But let’s put that aside for now.)

It’s been eight years since the last crisis ended.  Central banks simply cannot keep market interest rates that low for that long.  Instead, low market rates are best explained by widespread expectations of sluggish growth.  This is a supply-side phenomenon, not a demand-side one.  To the extent that central banks are contributing to this—and I believe a solid case can be made that they are—it is not through keeping their policy rate targets low.  It is the widespread uncertainty over the extent to which monetary authorities will continue propping up private sector balance sheets through preferential capital allocation.  This is an important consideration, but it is just one among many in a poor policy environment that is ultimately responsible for the lingering economic malaise.

Ultimately, the disappointing economic performance of Western economies since the end of the financial crisis has much more to do with factors outside of central bankers’ control.  As is usually the case, politicians are messing things up more than economists.