Benefits of Low Interest Rates
In a market economy, resources tend to flow to activities that maximize their returns for the risks borne by the lender. Interest rates (adjusted for expected inflation and other risks) serve as market signals of these rates of return. Although returns will differ across industries, the economy also has a natural rate of interest that depends on those factors that help to determine its long-run average rate of growth, such as the nation's saving and investment rates.4 During times when economic activity weakens, monetary policy can push its interest rate target (adjusted for inflation) temporarily below the economy's natural rate, which lowers the real cost of borrowing. This is sometimes known as "leaning against the wind." 5
To most economists, the primary benefit of low interest rates is its simulative effect on economic activity. By reducing interest rates, the Fed can help spur business spending on capital goods—which also helps the economy's long-term performance—and can help spur household expenditures on homes or consumer durables like automobiles.6 For example, home sales are generally higher when mortgage rates are 5 percent than if they are 10 percent.
A second benefit of low interest rates is improving bank balance sheets and banks' capacity to lend. During the financial crisis, many banks, particularly some of the largest banks, were found to be undercapitalized, which limited their ability to make loans during the initial stages of the recovery.
By keeping short-term interest rates low, the Fed helps recapitalize the banking system by helping to raise the industry's net interest margin (NIM), which boosts its retained earnings and, thus, its capital.7 Between the fourth quarter of 2008, when the FOMC reduced its federal funds target rate to virtually zero, and the first quarter of 2010, the NIM increased by 21 percent,