Exiting from Low Interest Rates to Normality: An Historical Perspective

This paper examines the Federal Reserve’s recent policy of quantitative easing by looking back at the experience of the 1930s and 1940s when the Fed, under Treasury control, kept interest rates at levels comparable to today and its balance sheet increased similarly. The paper also presents macroeconomic evidence based on the labor market, the growth of the money supply, and the behavior of real GDP and the unemployment rate in addition to a comparison of the Federal funds rate with the Taylor Rule rate and the shadow funds rate. Because of issues connected to its large balance sheet, the Fed may use tools other than the federal funds rate to tighten monetary policy. Returning to a higher (more normal) rate environment will remove some of the distortions that have accompanied the long period of abnormally low interest rates. But rising rates will also present problems for public finance and for the distribution of income that all but guarantees political rancor in the future.

Executive Summary

The recent financial recession ended in 2009. It has been followed by close to six years of abnormally sluggish growth. To allay the crisis and contraction, the Federal Reserve drove shortterm interest rates to the zero lower bound. To continue stimulating the economy, the Fed has followed a policy of quantitative easing (QE) which has more than tripled its balance sheet. The policy has kept both short-term and long-term interest rates at historically low levels. The U.S. economy is finally showing meaningful signs of recovery and, thus, the Fed stopped its QE policy at the end of October 2014. However, debate continues over the effectiveness of QE and the timing of the Fed’s return to normality either through an increase in its policy rate or by other means.

This paper examines the exit debate by looking back at the experience of the 1930s and 1940s when the Fed, under Treasury control, kept interest rates at levels comparable to today and its balance sheet increased similarly. Unlike the present situation of a recovery from a serious recession, rates were kept low back then to finance World War II and to fund the Treasury’s debt at favorable rates. The exit was accomplished when the Fed wrested its independence from the Treasury in the Accord of February 1951. The Fed could once again use the tools of monetary policy and raise interest rates to head off the growing problem of inflation.

The paper presents macroeconomic evidence based on the labor market, the growth of the money supply, and the behavior of real GDP and the unemployment rate in addition to a comparison of the Federal funds rate with the Taylor Rule rate and the shadow funds rate all indicating that the U.S. economy is now ready to return to the normal environment that prevailed in the Great Moderation. Because of issues connected to its large balance sheet, the Fed may use tools other than the federal funds rate to tighten monetary policy.

Returning to a higher (more normal) rate environment will remove some of the distortions that have accompanied the long period of abnormally low interest rates. But rising rates will also present problems for public finance and for the distribution of income that all but guarantees political rancor in the future. Rising rates will also present problems for emerging market economies and, in an international environment where several large economies will be loosening monetary policy, it will create imbalances and spillovers

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