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  • Mathieu Provencher

What's the deal with the Fed's interest rates?

(picture from Wix's library)

Hi Everyone!

There is a big hype about the USA's interest rates right now. A good amount of Economists are expecting the Federal Reserve (Central Bank of the USA) to increase them soon while another good amount of Economists are expecting them to stay low.

Remember that interest rates were decreased in a number of countries, including the USA, in response to the economic crisis of seven years ago. It was believed that decreasing interest rates and increasing money supply (strategies referred to as Quantitative Easing) would stimulate the economy and thus speed up the recovery.

The substantial and continuous increase in money supply has stopped not very long ago (see previous post for more details) but the interest rates have been kept low. Many economic agents (some of them Economists) are afraid that increasing interest rates could lead to a stop in the recovery at best and a new recession at worst.

Now, I personally don't think that an increase in interest rates would be damaging to the current recovery. Moreover, it seems clear to me that very low interest rates (such as the ones we have these days) can be quite damaging to the economy in the long-run.

That is because of what Hayek warned us about: mis-investment. Having very low interest rates means that borrowing is very cheap. That's the exact goal of expansionary monetary policies: make money cheap so that more people borrow... borrowing normally leads to more purchases, which helps economic activity.

That's all well and nice for short-term growth but it has other effects. The one I am worried about is that low costs of borrowing makes some unprofitable projects more viable. In times of "normal" interest rates (much higher than at the moment), projects need to generate a certain return in order to be able to pay back your debts. If your new factory or machine doesn't increase your sales enough (or decrease your costs enough), you won't be able to pay back your debt... this will lead to less of these unprofitable investments to be made.

However, when the interest rates are close to zero (and even negative in real terms), inefficient and unprofitable projects can still survive. This means that some firms will engage in less productive investments, taking money away from more productive projects (remember that the increase in money supply stopped). If this happens enough, we may be looking at a whole lot of bankruptcy when the interest rates finally increase again.

That effect is pushed by two forces: first, these bad projects generate very little profits, thus cannot pay much interests; and second, when interest rates increase, they increase for everyone... even if you took a loan at low interests in the past.

I am thus saying that higher interest rates would not be significantly damaging to the current economic recovery, and on top of that keeping low interest rates could be very damaging for the "near" future (10 to 15 years from now... or sooner).

I hope you guys enjoyed!

Keep an eye on what's going on, there is so much changing these days!!!!

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