New Research Suggests Raising Rates Can Cure the Economy

“The solution to weak economic growth may be higher interest rates.

That seemingly paradoxical remedy can apply if the cause of the slump is a confidence shock that cheap borrowing costs are failing to reverse, two Columbia University economists said in a report published this week. In such a situation, ultra-easy monetary policy risks making fears of deflation a self- fulfilling prophecy as spenders sit tight.

If low interest rates can’t motivate jittery consumers, then the answer may be the opposite: an increase in borrowing costs. Such a shift “can boost inflationary expectations and therefore foster employment,” said Stephanie Schmitt-Grohe and Martin Uribe in the study published Nov. 19 by the National Bureau of Economic Research in Cambridge, Mass.

“By its effect on real wages, future inflation stimulates employment, thereby lifting the economy out of the slump,” they said.

The academics said sagging confidence among households and companies has played a part in the recent economic slowdown. Evidence from the U.S. as well as Japan during the last two decades “seems to suggest that zero nominal interest rates are not doing much to push inflation higher.”

At the moment, the Federal Reserve pledges to keep its benchmark interest rate near zero through mid-2015.”

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