Former Treasury Secretary Larry Summers is probably right to warn the Fed, as he did a week ago in The Washington Post, not to hike interest rates on Thursday. That said, chronically low rates make economists anxious for good reasons: Pension funds, insurance companies, and private investors are desperate for high yields. Keeping rates low means that “secular stagnation”—very limited growth—would be a real concern, because if the global economy’s rate of expansion hovers just over 1 percent for the next 20 years, investments won’t dependably mature at a quick enough rate.
The Fed doesn’t control interest rates, but it can influence them by raising the rate that banks charge each other when transferring money. Economic theory says that if the Fed stimulates the economy too much, by keeping rates too low, it might induce inflation. But, as Summers has noted, this does not seem to be our situation at the moment—the unemployment rate is low enough that wages aren’t increasing, which means prices probably won’t wildly increase either. In Kansas, for example, unemployment has been below 4 percent for years, but wages have been staying put.
But what would be potentially worrying about low interest rates is that the prices of many assets may currently be artificially high, which may constitute the best case for the Fed to gradually raise rates. It’s likely that the assets that pension funds and households tend to invest in are currently overvalued, which is the product of irrational exuberance in the market. Housing prices, for example, are soaring, due to low mortgage rates and even lower gas prices, which can make living in the suburbs more compelling to commuters.
The OECD, the research arm for the world’s richer nations, warns that pension-fund managers and life-insurance companies (as well as, I would argue, households) might be increasing their chances of going bust by aggressively investing in risky assets—hedge funds, private equity, commodities, junk corporate bonds, and condos and houses. Chasing high returns with such investments feels better in the short-term than soberly adhering to a budget, but hope is not an investment plan. (Workers, at least, have wised up to the fact that their pension funds or endowments may not be as robust as expected, and have started saving up money themselves.)
The financial crisis, after all, has not changed the two basic guidelines for investing. The first is to diversify, as dictated by modern portfolio theory. Fine—pension funds should pick out a variety of assets based on their riskiness and thus their likelihood to provide the returns needed to pay out those who depend on them after retirement. But the second guideline is that saving money for the future requires deferring consumption now—which is true for both college students and college-endowment funds. (While some parts of the economy—households and pension funds, most notably—should be in a saving mentality, others should be investing. The government would be wise to put aside its reservations about spending and invest in infrastructure, which usually leads to economic growth.)
Even though monetary policy can only go so far in altering the course of the economy, a perk of the Fed raising rates on Thursday would be that pension funds and households would be more inclined to put money away into savings rather than into what are probably overheated assets anyway. Again, Summers is ultimately correct that keeping rates low is probably the best course of action, but if there's a rate hike, at least there would be a silver lining.