Let’s Increase Interest Rates to Encourage Credit Growth

Since I read this article in yesterday’s Financial Times from Bill Gross I have been searching all my macroeconomics books for a model that explain the logic of the article. I have not found it yet. I am glad that I am not teaching a macroeconomics course now because I do not know what I would answer if my students asked me to explain the logic of the article…

The argument is that Ben Bernanke has destroyed credit creation in the US by making the yield curve flatter in the 0-2 years horizon (and he did this with his statement that Federal Funds rate will be zero for the next two years). According to the article, the flattening of the yield curve reduces lending by banks because it reduces the potential return to banks of borrowing short term and lending at a two year horizon.

I understand that a strong recovery is normally associated with an upward slopping yield curve and the fact that we have a flat curve is bad news. But by committing to keep short term interest rates low for an extended period of time, the Fed is providing incentives for banks and investors to move into riskier assets (lending to companies, consumers) within that horizon. This should create lending, nor destroy it. This is what a macroeconomics textbook says (including the one written by Ben Bernanke). Reducing Fed rates does not change per se the returns of investment in other assets, it just makes the differential with the riskless asset even larger and creates an incentive to borrow/lend. There are many yield curves, one for each class of asset and the Fed policy can only influence (directly) the one associated to riskless assets.

Of course, it can be that Ben Bernanke’s action changed our expectations of the future and we are now more pessimistic than before so lending will be destroyed after all, but this is not a direct consequence of lower interest rates but of the management of expectations.

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About Antonio Fatás 136 Articles

Affiliation: INSEAD

Antonio Fatás is professor of Economics at INSEAD. He is a Research Fellow at the Centre for Economic and Policy Research in London and has worked as external consultant for international organizations such as the International Monetary Fund, the OECD and the World Bank.

He teaches the macroeconomics core course in the MBA program as well as different modules on the global macroeconomic environment in Executive Education. His research is focused on the study of business cycles, fiscal policy and the economics of European integration. His articles appear in academic journals such as the Quarterly Journal of Economics, Journal of Monetary Economics, Journal of Money, Credit and Banking, Journal of Public Economics, Journal of International Economics, Journal of Economic Growth, European Economic Review or Economic Policy.

Professor Fatás earned his M.A. and Ph.D. from Harvard University, and M.S. from Universidad de Valencia.


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