1. Why Interest Rates are So Low
Sean Ling | Mobile Phone: 949-680-8258
Email: syling@wisc.edu
Abstract
As the United States economy recovers from the financial crisis of 2007-2009, the Federal
Reserve is currently planning to stop both quantitative and credit easing. However, over the past
year neither nominal nor real interest rates have risen despite the Fed's intervention in the US
economy. In this paper, I will document trends in interest rates, explain competing theories for
the determination of interest rates, and use data and/or econometric analyses to explain what
my preferred explanation is.
What are Interest Rates and Why do they
Matter?
There are three components of interest rates:
1. The originary rate, or the rate needed to turn someone from a spender into a saver; i.e., from
a consumer into a lender.
2. The debtor’s risk premium, or the amount of compensation needed to cover the risk of
default by the borrower.
3. The inflation premium, or the amount of compensation needed to cover the risk that the
lender will be paid back with money of a lesser purchasing power.
In the United States, interest rates are decided by the Federal Reserve. The Fed meets

2. eight times a year to set short-term interest rate targets. During these meetings, the CPI and
PPIs are significant factors in the Fed's decision.
Interest rates directly affect the credit market because higher interest rates make
borrowing more costly. By changing interest rates, the Fed tries to achieve maximum
employment, stable prices and a good level growth. As interest rates drop, consumer spending
increases, and this in turn stimulates economic growth.
In its own words, the Fed has learned that low interest rates “help households and
businesses finance new spending and help support the prices of many other assets, such as
stocks and houses.” (http://www.federalreserve.gov/faqs/money_12849.htm) What the Fed
has overlooked is that spending, in itself, is not necessarily good. It can also be wasteful and
misguided.
By keeping interest rates low for an extended period of time, businesses and households
are encouraged to borrow more money, and they can use that money to expand their
operations. Nevertheless, over time, the benefits of low interest rates diminish and some
potential problems can arise:
1. Some businesses may borrow too much, become over-extended and either can’t afford to
repay the funds (resulting in bankruptcy), or are bought out by someone else with more cash
and/or less debt.
2. When money is easy to borrow, borrowers tend to bid up prices of goods, such as housing
and stocks, thus creating a bubble in some industries.
3. At some point, when artificially-maintained low interest rates rise to a market rate, borrowers
who cannot make their rising interest payments (are over-extended) fail or sell out. If enough

3. people fail, a banking crisis results.
4. People may invest more heavily in things that are easier to borrow against and forgo investing
in things that are more difficult to borrow funds for. For example, they might invest in housing
instead of manufacturing, or in military suppliers rather than farming.
These problems were adressed in a study by the International Monetary Fund's
Research Department, titled World Economic Outlook, October 2014:: Legacies, Clouds,
Uncertainties. According to the study, "robust demand growth in advanced economies has not
yet emerged despite continued very low interest rates and easing of brakes to the recovery,
including from fiscal consolidation or tight financial conditions." It is true that with low interest
rates and increased risk appetite in financial markets, equity prices have increased, spreads have
compressed, and volatility has declined to very low levels. However, the further declines in
nominal and real interest rates on long-term “safe” government bonds during the past few
months—despite expectations of a strengthening recovery—underscore the fact that stagnation
risks cannot be taken lightly.
While short-term interest rates reflect the current economic environment, long-term
interterst rates also reflect expectations about the future. Therefore, if the government has a
budget surplus today, as was the case during the Clinton administration, the surplus reduces the
total supply of savings, thereby lowering short-term inerest rates. Conversely, if the government
is expected to run a deficit starting next year, this will put upward pressure on long-term
interest rates. Since businesses tend to make long-term capital investments, they tend to focus
on long-term interest rates more closely. Consequently, the issue of whether the government
runs deficits or surpluses in the future matters for capital accumulation in addition to savings
and investment today.

4. Competing Theories Regarding Recent Low
Interest Rates
Standard economic theory states that higher budget deficits lead to higher interest rates
and less capital investment, though it does not reveal how much higher and how much less. The
existing empirical literature on this question is somewhat inconclusive, although recent
evidence suggests that projected long-term deficits are to some extent correlated with higer
interest rates. A study conducted by Gale and Orszag in 2003 conculded that for every 1% of
GDP increase in the U.S. government's budget deficit, long-term interest rates rise by between
0.5% and 1%. (http://www.brookings.edu/views/papers/gale/20030717.pdf)
In August 2007, the Federal Open Market Committee's (FOMC) target for the federal
funds rate was 5.25 percent. Sixteen months later, with the financial crisis in full swing, the
FOMC had lowered the target for the federal funds rate to nearly zero, thereby entering the
unfamiliar territory of having to conduct monetary policy with the policy interest rate at its
effective lower bound.
A recent phenomenon known as a liquidity trap coupled with Federal Reserve
announcements that the US was no longer in a recession at the end of 2009 led several
economists to predict that since interest rates cannot fall below zero, the Federal Reserve would
eventually have no choice but to raise interest rates in order to avoid inflation in the near
future. A liquidity trap is a situation, described in Keynesian economics, in which injections of
cash into the private banking system by a central bank fail to decrease interest rates and hence
make monetary policy ineffective. This occurred in the United States in 2008–2010, as short-
term interest rates for the Fed moved close to zero, and fiscal policy was the only other

5. alternative. Fiscal policy usually involves government spending, which requires the U.S.
government to borrow money, which in theory raises interest rates. However, the interest rate
from 2010 to 2014 did not rise, leading investors and economists alike to come up with
explanations of their own.
A possible explanation of why interest rates remained low is that short-term interest
rates are typically low when the economy has encountered a slowdown or entered a recession,
as was the case in 2007-2009. The Federal Reserve responded by lowering the discount rate and
the deposit rate to rates as low as 0.5% in 2008-2014. In addition, as interest rates declined, the
Federal Reserve announced plans to undertake quantitative easing in 2008, 2010, and 2012.
Since quantitative easing is used to lower longer-term interest rates further out on the yield
curve, investors naturally predicted a sequence of low short-term rates in the near future.
According to the Expectations Hypothesis of the Term Structure, these expectations typically
result in the long-term interest rate being lower than usual even as 2014 was coming to an end.
Another possible explanation involves recent Federal Reserve Actions. At the end of
March 2014, Federal Reserve Chair Janet Yellen announced her belief that the still-subpar U.S.
job market will continue to need the help of low interest rates "for some time." Her remarks
sent a reassuring message to investors, many of whom had grown anxious that the Fed might
raise short-term rates by mid-2015. Their concerns were stirred a couple of weeks ago, when
Yellen suggested that the Fed could start raising short-term rates six months after it halts its
bond purchases, which most economists expect by year's end. A short-term rate increase could
elevate borrowing costs and hurt stock prices; however, from April 2014 onward, Yellen
indicated that the Fed still thinks rates should remain low to stimulate borrowing, spending and
economic growth. "I think this extraordinary commitment is still needed and will be for some

6. time, and I believe that view is widely held by my fellow policymakers at the Fed," Yellen said in
her first major speech since taking over the Fed's leadership in February.

7. time, and I believe that view is widely held by my fellow policymakers at the Fed," Yellen said in
her first major speech since taking over the Fed's leadership in February.