The low interest rate environment, which has been the Fed’s mode of operation for much of the last decade, has been instrumental in stabilizing the U.S. financial system—but continued low interest rates could put pressure on some financial institutions’ business models, according to Fed Governor Jerome Powell over the weekend.
From the end of 2006 until the Fed raised rates by 25 basis points in December 2015, the federal funds target rate was 0 to .25 percent. The Fed forecasted four more rate hikes for 2016, but only one actually happened, which took place in December as the target rate was increased to 0.25 to 0.50 percent. The Fed is predicting three rate hikes for this year.
“I will argue that ‘low for long’ interest rates have supported slow but steady progress to full employment and stable prices, which has in turn supported financial stability,” Powell said, speaking at the Annual Meeting of the American Finance Association in Chicago. “Indeed, by many measures the U.S. financial system is much stronger than before the crisis.”
Powell cited that improved risk management at the largest financial institutions, which have been designated as “systemically important financial institutions (SIFIs)” by the Fed, along with stronger regulation have strengthened the core of the U.S. financial system, making it stronger and more resilient than it was pre-crisis.
“The SIFIs have more stable funding, hold much more capital and liquidity, are more conscious of their risks, and are far more resolvable should they fail,” Powell said. “Many aspects of our financial market infrastructure, including the triparty repurchase agreement (or repo) market, central counterparties (CCPs), and money market funds are more robust as well.”
Despite the positives of keeping interest rates low over the last decade, at times there will be tradeoffs, Powell said. Low interest rates are meant to encourage some risk-taking, but the question is whether or not those low rates have encouraged excessive risk-taking by financial institutions through buildup of leverage, unsustainably high asset prices, or misallocation of capital, according to Powell.
“Historically, recessions often occurred when the Fed tightened to control inflation,” Powell said. “More recently, with inflation under control, overheating has shown up in the form of financial excess. Core PCE inflation remained close to or below 2 percent during both the late-1990s stock market bubble and the mid-2000s housing bubble that led to the financial crisis. Real short- and long-term rates were relatively high in the late-1990s, so financial excess can also arise without a low-rate environment. Nonetheless, the current extended period of very low nominal rates calls for a high degree of vigilance against the buildup of risks to the stability of the financial system.”
Long-term low interest rates have put pressure on profitability in the financial sector, but firms have coped with the pressure and the largest banks in particular have not taken on excessive risks since the crisis, partly because of the heightened regulatory environment and partly because of their own attitude toward risk, Powell said.
“Still, a period of low rates for a long time could present significant challenges for monetary policy,” he said. “It could also put pressure on the business models of some financial institutions. Ultimately, the only way to get sustainably higher interest rates is to improve the broader environment for growth, by adopting policies designed to increase productivity and potential output over the long term--policies that are mainly outside the scope of our work at the Federal Reserve.”
Click here to read Powell’s complete speech.