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.

• Create Content With AI
• Become A Funded Futures Trader