Taking the long view on Wall Street
Taking the long view on Wall Street
Noah Smith


NEW YORK — In the celebrated sci-fi comedy "The Hitchhiker's Guide to the Galaxy," a supercomputer determines that the answer to life, the Universe, and everything is the number 42. The really difficult task, however, is figuring out what the question was in the first place.

Sometimes I feel like interest rate hikes are a little like that. There is a legion of economists, commentators, government officials and businesspeople who are constantly calling on the Federal Reserve to end its zero interest rate policy, or ZIRP. Whether the problem is the threat of inflation, or excessive risk-taking in search of higher returns, or the idea that low rates hurt savers, rate hikes are the answer. Rate-hike-ism is a hammer, forever in search of a nail.

This has led a number of commentators to go "meta" in their thoughts about interest rates. Instead of asking whether we should raise rates, they are asking why some people so consistently yearn for the Fed to tighten. Since some of the loudest grumbling about ZIRP tends to come from the financial industry, much thought has gone into the question of why Wall Street hates easy money.

Recently, some commentators say they believe that they have hit upon the answer — it's all about net interest margins, or the spread between a bank's borrowing costs and lending rates. When this difference narrows, bank profits get squeezed. John Carney of the Wall Street Journal asserts that ZIRP is compressing that spread:

"The primary driver of falling net-interest income has been a squeeze on net-interest margins...The unusually long period of ultralow rates has compressed margins by more than 27% since 2010."

Paul Krugman concurs, and goes even further, suggesting that a small group of very influential banks is behind much of the anti-Fed sentiment. He writes:

"Commercial bankers really dislike a very low interest rate environment, because it's hard for them to make profits: there's a lower bound on the interest rates they can offer, and if lending rates are low that compresses their spread. So bankers keep demanding higher rates, and inventing stories about why that would make sense despite low inflation...So the demand for higher rates is coming from a narrow business interest group."

Krugman's general model of political economy — that narrow interests wield enormous clout on single issues — might be a good one, but in this case, I am not sure that he and the other commentators have the story right. The idea that a low federal funds rate compresses net interest margins doesn't make much sense to me, and I don't see a lot of data bearing it out.

First of all, if we simply look at the history of interest rates and net interest margins, we don't see much of a relationship at all:

The fed funds rate has been falling since the early 1980s, but until the mid-1990s, net interest margins actually rose. After 1994, net interest began a steady but very slow decline that continues to this day. During this whole time, the fed funds rate has gyrated dramatically, but net interest has barely budged in response to those swings. A careful time-series analysis might be able to tease out some sort of a relationship there, but I don't see it.

Then there's the lack of a good theory for why lower interest rates should compress banks' margins. Changes in the fed funds rate should affect both long-term and short-term rates equally. If the Fed tightens, depositors will demand higher deposit rates from banks, and banks will demand higher interest from borrowers. After an initial period of adjustment (to allow for existing loans to roll over), the effect of rate changes on spreads shouldn't be substantial.

Now, as Krugman points out, deposit rates — like the federal funds rate — are stuck at zero. If deposit rates stay at zero while the returns on bank loans fall, that does indeed compress banks' margins. But it's very hard to see how Fed tightening would help that situation at all. As David Henry of Reuters points out, that would just increase banks' costs in the short run. On top of that, if rate hikes slow economic growth — as they did in the early 1980s — that will hurt banks' profits even more.

If banks really do think that Fed tightening would boost their bottom lines, history is not on their side. When Japan temporarily ended its own ZIRP in 2006, the result was simply higher costs for banks, with no corresponding rise in profits.

So if we want to find the reason that Wall Street wants higher interest rates, we should probably look elsewhere. Here's a thought: perhaps high rates make it easier to charge bigger percentage fees at every stage of the investment process. But that's a topic for another column.

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