07 March 2016
It is conventional wisdom that higher interest rates hurt the real economy because they raise the cost of loans and thus reduce the demand for them. This also explains the clamour for lower rates whenever the economy runs into trouble.
It may therefore surprise economists to learn that the facts point the other way. The graph below shows the YoY change in Commercial and Industrial Loans (for all commercial banks) v/s the Effective Federal Funds Rate. From 1973 onwards it shows that commercial and industrial loans respond positively to a rise in interest rates.
This may seem very odd. But the explanation is actually quite simple. Very low interest rates benefit the financial sector at the expense of the real economy. When interest rates are raised money moves from financial asset markets into the real economy.
When the Fed sees this effect it concludes that money supply is expanding and continues to raise rates, when what is happening is quite the opposite (as my previous post showed). At a certain point in the upward trajectory of interest rates the financial asset markets collapse leading to a recession.