HIGHER INTEREST RATES SPUR GREATER INVESTMENT
That appears to be the central claim of Kevin Warsh and Stanley Druckenmiller in a Wall Street Journal column criticizing the Fed’s asset buying program. The central claim appears to be that because asset prices have been rising, companies have been discouraged from undertaking productive investment.
While Warsh and Druckenmiller are certainly right that the asset buying program has had limited benefits for the real economy, it doesn’t follow that the economy would be stronger without it.
First, they misrepresent the wealth situation when they tell readers:
“The aggregate wealth of U.S. households, including stocks and real-estate holdings, just hit a new high of $81.8 trillion. That’s more than $26 trillion in wealth added since 2009.”
The sharp rise in wealth since 2009 was due to a sharp plunge in the financial crisis. The notion of a “record” is misleading since the economy is growing we expect wealth to continually hit records. The ratio of wealth to GDP was 4.78 in the first quarter of 2014. By comparison, it was 4.86 for 2006. The Fed’s policies have simply brought the ratio of wealth to GDP back to pre-recession levels.
More importantly, Warsh and Druckenmiller seem to turn causality on its head when they say:
“Meanwhile, corporate chieftains rationally choose financial engineering—debt-financed share buybacks, for example—over capital investment in property, plants and equipment.”
Lower Interest rates encourage additional investment spending, which gives the economy a boost in times of slow economic growth. The Federal Reserve Board is in charge of setting interest rates for the United States through the use of monetary policy. According to US News, the Fed adjusts interest rates to affect demand for goods and services. Interest rate fluctuations can have a large effect on the stock market, inflation and the economy as a whole. Lowering interest rates is the Fed’s most powerful tool to increase investment spending in the U.S. and to attempt to steer the country clear of recessions.
Ultimately, the Fed uses monetary policy to keep the economy stable. In times of economic downturn, the Fed lowers interest rates to encourage additional investment spending. When the economy is growing and in good condition, the Fed takes measures to increase interest rates slightly to keep inflation at bay. The Fed controls the federal funds rate, which influences long-term interest rates. The federal funds rate is the interest banking institutions charge one another for overnight loans of reserves or balances that are needed to meet minimum reserve requirements set by the Fed. By setting the federal funds rate, the Fed indirectly adjusts long-term interest rates, which increases investment spending and eventually affects employment, output and inflation.
Changes in interest rates affect the public’s demand for goods and services and, thus, aggregate investment spending. A decrease in interest rates lowers the cost of borrowing, which encourages businesses to increase investment spending. Lower interest rates also give banks more incentive to lend to businesses and households, allowing them to spend more.
Low interest rates encourage corporations to invest in stock rather than bonds. If interest rates were higher, then presumably they would do the opposite. Low interest rates (and high stock prices) make it easier to borrow to finance capital investment in property, plants and equipment. It is hard to imagine why they think firms would be investing more, if it cost them more money to make these investments.