President Biden’s $1.9 trillion COVID relief package has triggered a vibrant debate among economists. Critics of the package argue that it fails to target the neediest recipients; that it is far larger than needed to boost the economy to full employment; and that it will accordingly re-ignite inflation and expand the federal debt to an egregious extent. Proponents point to the very unequal nature of the nation’s recovery; that after years of subdued inflation, there is no evidence that the expansion will produce anything more than a short-lived spike in prices; and that in light of the tremendous challenges posed by the ongoing pandemic, going big is less risky than going small.
While all of these arguments have merit, another benefit of substantial fiscal stimulus has largely been ignored: that it will enable a return of interest rates to higher levels and thus help to restore balance to our economy and financial sector. For years after the 2008 financial crisis, fiscal caution put the onus on the Federal Reserve to support the economy, making monetary policy “the only game in town.” And with other sources of spending – consumer purchases, business investment, foreign sales – also relatively weak, the level of real (inflation-adjusted) interest rates needed to balance the economy, often referred to as the natural rate of interest, or r*, has declined. According to estimates by the Federal Reserve Bank of New York, r* moved down from around 2.5 percent in the years before the financial crisis to roughly 1 percent prior to the advent of the pandemic. And the Federal Reserve, with its 2 percent inflation target and its mandate of full employment, has had to reduce its policy interest rate along with r*.
When declines in interest rates prompt businesses to borrow more in order to invest in equipment and other productive assets, this not only boosts spending and employment in the present, but it lays the foundation for future growth and prosperity. But lower interest rates likely are no longer boosting business capital expenditures the way they used to. Interest rates are already far below the rates of return targeted for projects by management; and with corporations in recent years earning more in profits than they’ve spent on investment, they’ve amassed piles of cash that reduce their dependence on borrowing.
With business investment less responsive to interest rates, it falls to other channels of monetary transmission to do the heavy lifting of economic stimulus, and these have problems of their own. Boosting housing investment, if carried on for too long, risks a replay of the subprime crisis. Encouraging other forms of household spending merely shifts consumption from the future to the present, a dubious benefit for the millions of Americans already on track to miss their retirement goals. Stimulating stocks and other asset prices carries the potential for excessive valuations and bubbles; this channel may also exacerbate inequality, as it will benefit wealthier portfolios more than those of poorer households. Finally, prolonged low interest rates hurt savers and damage the balance sheets of insurance and pension funds, an especially important concern for many states and municipalities.
In the absence of substantial further fiscal stimulus, a resurgence of the pandemic or other adverse shock that held back the economy’s recovery could mean years of continued low interest rates. Conversely, a robust recovery fueled by fiscal spending would allow the Fed to more rapidly reduce its asset purchases, raise interest rates off their floor and get them to more normal levels.
To be sure, such a tightening of financial conditions carries risks of its own, especially if prompted by a sharp and persistent rise in inflation: It could in principle trigger a disruptive crash in asset prices and defaults by companies that borrowed heavily over the past year. But a sustained inflationary surge does not seem the most likely scenario, and businesses and markets should be able to handle higher rates driven by a stronger economy. Indeed, even as bond yields have risen amid expectations of the stimulus package and higher inflation, stock prices have risen further and high-yield corporate bond spreads have continued their decline.
A substantial fiscal stimulus package would, of course, enlarge the federal debt. But current low interest rates allow the government to finance its spending very cheaply, and as the issuer of the world’s preeminent reserve asset, it is doubtful that the federal government is anywhere close to its borrowing limit. It therefore makes all the more sense to move from our prior dependence on monetary stimulus and rising private-sector debt to a more balanced approach involving more fiscal stimulus and government debt.
Steven Kamin is a resident scholar at the American Enterprise Institute (AEI), where he studies international macroeconomic and financial issues. Before joining AEI, Dr. Kamin was the director of the Division of International Finance at the Federal Reserve Board.