In a recent blog post, Alex Salter discusses the problem of reasoning from a price change in the context of interest rates. Simply put, observing a low interest rate does not necessarily mean that monetary policy is loose (or tight!). Instead, we should consider what caused this price to change.
Low real interest rates could be the result of an increase in supply of or decrease in demand for loanable funds. An increase in supply results when individuals are willing to save more for a given interest rate—or, to state the matter differently, to supply just as much loanable funds at a lower interest rate. Monetary expansions can also increase the supply of loanable funds—at least in the short run—since prices do not adjust instantaneously. But, in the long run, monetary policy probably doesn’t have much of an effect on real rates. As former Fed Chair Ben Bernanke recently wrote: “The Fed’s ability to affect real rates of return, especially longer-term real rates, is transitory and limited.”
The demand for loanable funds depends, in large part, on technology. An improvement in technology allows us to produce more with less. An investor will, quite naturally, be willing to pay more (less) to borrow the same amount of funds today as the amount that can be produced with those funds increases (decreases). Similarly, since improvements (reductions) in technology means consumers will have more (less) income in the future, consumption smoothing requires that they try to borrow more (less) to realize more (less) consumption today.
Since most people focus on the supply side, let’s take a look at demand. The Federal Reserve Bank of San Francisco provides a standard measure of technology known as utilization-adjusted total factor productivity. Using this data, I’ve constructed the simple Technology Index shown below. The 2000-2005 trend line clearly demonstrates that the growth in technology fell in late 2005/early 2006 and has been on a lower trajectory in the time since.
The decline in the growth of technology puts downward pressure on demand. Investors and consumers are not willing to pay as much to borrow as they were before. As demand falls, so does interest rates.
Is this the whole story? Almost certainly not. We live in a very complicated world. Still, it is an important part of the puzzle that many considering monetary policy tend to over look. Indeed, it is arguably the failure to consider changes in productivity that generated the housing bubble.