Interest rates in the United States are extremely low by historical standards. They have remained low for years, fixed by frustrated central bankers dedicated to performing monetary experiments on the economy. The Fed normally offers academic and theoretical explanations for super-low interest rates, but practical reality and political interests also play their parts.
Very Low for a Very Long Time
As of May 19, 2016, the effective federal funds rate was at 0.37%, almost exactly midway inside the Federal Reserve's target range of 0.25 to 0.5%. A 0.37% nominal rate is low, yet this is the highest realized rate since late 2008. That is when the Fed established a target range and moved away from a specifically set fed funds rate. The Fed used to peg overnight loans at 1, 5 or 15%. Starting in December 2008, the Fed moved from a 1% set rate to a target rate between zero and 0.25%.
The Fed had never set interest rates at 0% before, as it worried that this might panic money markets. Money market fees would almost certainly exceed paid interest with a 0% fed funds rate, scaring away participants in a very large market. The new target range increased flexibility to coordinate with money market dynamics.
The Fed's Zero Interest Rate Policy and Excess Reserves
Ben Bernanke, then chairman of the Fed, justified the zero interest rate policy (ZIRP) in 2008 as a mechanism for boosting spending, borrowing and investment. This is classic Keynesian monetary theory: discourage savers by lowering rates, forcing them to spend, encourage spenders to spend even more through cheap borrowing costs and drive investments from safer assets, such as Treasurys and certificates of deposit (CDs), into riskier equities or junk bonds.
The ZIRP era of 0 to 0.25% lasted seven years, between December 2008 and December 2015, until the Federal Open Market Committee (FOMC) finally increased its target fed funds rate. The Fed emphasized, "The stance of monetary policy remains accommodative after this increase, thereby supporting further improvement in labor market conditions and a return to 2% inflation."
Seven years of ZIRP also coincided with a brand new policy; the Federal Reserve began paying interest to big banks if they parked excess reserves at the Fed bank. In 2015, 93% of Fed bank reserves were excess. The Fed paid more than $100 million to Goldman Sachs Group Inc.. (NYSE: GS) in 2015, while JPMorgan Chase & Co. (NYSE: JPM) received more than $900 million. When the Fed hiked the rate range from 0.25 to 0.5%, it also doubled the rate paid on excess reserves.
Keynesian theory says more spending and more debt are stimulative, thanks to the circular flow model of the economy. If this is the reasoning behind ZIRP, why pay interest to banks on excess reserves? After all, the Fed made it more profitable for banks not to make overnight loans to each other. It was also far safer to not make loans to the public or invest in a speculative market.
The Fed offered two explanations for interest payments on excess reserves. The first explanation was that it worried that too much bank lending would make the money supply hyperactive, triggering very high inflation; and second, that it wanted a firmer, non-zero floor on short-term interest rates. Ostensibly, this could have been better accomplished by raising the target rate from 0.25 to 0.5% in 2008, rather than from 0% to 0.25%.
Practical and Political Reality
There are more practical and less romantic explanations for low rates and excess reserve payments, but they call into question the Fed's oft-touted independence. The first explanation surrounds the U.S. government's enormous debt. By the fourth quarter of 2015, nearly two-thirds of the national debt was serviced by government bonds with a duration under one year. Ultra-low interest rates help the Treasury afford its bills. ZIRP also inflates the stock market, something sitting politicians and wealthy investors desire.
Second, the Federal Reserve has a very cozy relationship with major banks. Private banks choose six of the nine directors for the Federal Reserve banks. A rotating employment door exists between many Fed branches and major financial institutions. In 2011, Congress forced a partial audit of the Fed and found $16 trillion in previously unknown allocations to corporations and foreign banks. The Fed has heavily resisted calls for further audits.
Results Have Been Poor
Results from easy money, debt and spending policies have been underwhelming, regardless of the reasons. Empirically, the policies employed by the Federal Reserve were unsuccessful by their own standards and stated goals, though proponents offer a counterfactual defense along the lines of "things might have been even worse" without these efforts.
After nearly a decade of ultra-low interest rates, buoyed by enormous government deficit spending, the U.S. economy found itself with the slowest recovery in its history. Policymakers have been very hesitant to change, however, and very few expect a different course anytime soon. The net effects for average Americans have been disappointing, but theoretical, practical and political pressures for low rates are still in place.