How Attention to Fed Policy Distracts Us from the Real Problem

Can US financial markets remain robust even without ultra-low interest rates?

While not often stated openly, many on Wall Street believe the answer is no. Some have been trying to persuade the Federal Reserve to stop raising interest rates, and even to begin lowering them. The recent collapses of Silicon Valley and Signature Banks, largely a consequence of rates rises, will probably only bolster their case.

But why should any of this matter to ordinary Americans?

Whether or not we like to think about it, most of us have grown addicted to low interest rates. Quite simply, low rates mean that money is cheap. And persistently low rates have allowed pretty much all of us – from Wall Street to Main Street – to live way beyond our means. 

Low interest rates have caused massive borrowing and for a very long time. And good thing for the US economy too; even though the inflation-adjusted wage of the average middle-class American has barely budged for 50 years, US consumer spending has mostly remained healthy in all this time. But household debt has truly skyrocketed over the past four decades, increasing from $1.3 trillion in 1980 to almost $19 trillion today.

And even this understates the extent of the problem. Low interest rates have not only made it easier to buy a home; they have helped multiply average home prices since the mid-1990s. More valuable property across the board created a wealth “illusion” that motivated even more spending, at least until the banking collapse the led to the Great Recession. As we know, it led to an even sharper drop in interest rates, and the Fed funds rate has remained at rock bottom ever since. At least until last year.

Sufficiently high interest rates would surely break our addiction to borrowing, but possibly at great cost. Not only do higher rates make it harder to borrow money, but they also make servicing existing debt more challenging. Think, for example, of the monthly charges that tens of millions of consumers pay on their credit cards. Higher rates mean higher monthly payments and less money available for necessities like food or gasoline. Other things also become more expensive, such as car payments or student loans. This would translate to a lower standard of living.

Not only the middle class has been living beyond their means, of course. US government debt has ballooned from $1 trillion in 1980 to almost $30 trillion today – yet we continue to raise the debt ceiling. Corporate America is also increasingly in hock. All US debt combined was only about one and a half times GDP in 1975; in 2021 it was almost fourtimes GDP.

Some say that none of this should matter because it is only some Americans owing money to other Americans. But when debt becomes the very foundation of economic value, everything starts to smell fishy.  

Fortunately, recent evidence reveals that inflation may be slowing. This and the collapse of Silicon Valley and Signature Banks now increase pressure on the Fed to reverse course and start lowering rates again.

Yet let us be clear: Headlines and hype aside, interest rates remain extremely low by historical standards. Even now the Fed funds rate sits at just 4.5 percent – far, far lower than the near-20 percent it reached under then-Fed Chair Paul Volker 40 years ago. And in real — that is, inflation-adjusted — terms, the rate sits at about negative 2.5 percent and has remained in negative territory for virtually the entire past decade.

Imagine that. Zero interest means that the bank pays you nothing for keeping your money with them; negative interest means that they charge you for your trouble! 

So, interest rates really do have lots of room to move on the upside. The fact that even the modest increases we have seen provoked such bank failures reveals how serious our addiction to money is. Much of today’s debate is really over whether even a slight reduction to our steady dose of easy money will be too disruptive to the financial markets – and, by extension, the economy. That, of course, is the headline we never see.

Low rates seem to be here to stay. Our market economy’s dependence on cheap money seems unshakeable. We already know that inflation is the price we pay. We should hope that it will not spiral out of control.