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Artificially low interest rates: Negative unintended consequences

Montreal, March 31, 2022 – While lowering interest rates has a short-term stimulative effect, maintaining low rates over a longer period of time may have the opposite effect, of inhibiting growth and productivity improvements, according to a Montreal Economic Institute researcher.

Jerome Gessaroli, Senior Fellow at the MEI and professor of Finance at the British Columbia Institute of Technology, has studied the effects of the Bank of Canada’s sustained low-interest rate monetary policy. In a new MEI paper, he recommends a series of policy actions that both the central bank and the federal government can undertake to help alleviate the negative effects of this expansionary policy on the population and ensure the economic health of the country.

“If the central bank does not allow more market-driven interest rates, adverse consequences will follow. At this moment, we are facing several problems such as housing affordability, resource misallocation, and rising debt, all due in part to very low interest rates over a long period,” observes Jerome Gessaroli.

While raising interest rates is part of the solution, it is not the whole solution. Interest rates are a blunt tool, so using them can have suboptimal outcomes. “Interest rate policy is like a dull scalpel that a surgeon uses to remove an appendix. The surgeon may get the job done, but the patient will suffer ragged tissue cuts, greater blood loss, more likely infection, and scarring,” explains Jerome Gessaroli.

There is no short-term magic bullet to get back on track quickly, but there must be a return to budgetary discipline, and interest rates must not be kept artificially low as they have been for some time now.

“The government needs to rediscover fiscal discipline, combining cuts to discretionary consumption expenditures and productivity enhancing policies in order to get back on a sustainable fiscal path. Households, companies, and governments have taken on too much debt, and productivity growth has slowed, as has wage growth. Both monetary and fiscal measures will be required to right the ship,” concludes Jerome Gessaroli.

Six recommendations:

  1. Reduce the Bank’s influence on interest rates

It is important to realize that monetary policy can take up to two years before its full effects are felt in the economy. If inflation is not transitory, continued ultra low interest rates and quantitative easing, along with planned government stimulus spending, could be the equivalent of air dropping gasoline on a forest fire.

  1. Show fiscal discipline

The federal government’s debt-to-GDP ratio should be reduced by slowing the growth of spending, primarily in discretionary consumption programs rather than capital and infrastructure projects.

  1. Pursue economic growth policies

Policies that improve growth and productivity enable the economy to escape the debt trap, and to alleviate distortions from continuous low interest rates. The country’s productivity and competitiveness could be improved by reducing the regulatory burden and reviewing the tax system.

  1. Lengthen the maturity term of government issued bonds

The federal government should take advantage of current low interest rates and finance its borrowing requirements by issuing more long-dated bonds.

  1. Make monetary policy more symmetrical

Going forward, the Bank of Canada should ease and tighten monetary policy in approximately equal proportion.

  1. Favour resiliency rather than stability in the financial system

Policies should allow the financial system to expand and contract based on economic signals, yet still be able to provide its key functions in times of significant stress.

To read the full publication, click here.

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The Montreal Economic Institute is an independent public policy think tank. Through its publications, media appearances, and advisory services to policy-makers, the MEI stimulates public policy debate and reforms based on sound economics and entrepreneurship.

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