When the Federal Reserve Open Market Committee meets this week, they will discuss whether to raise interest rates for the first time in three years. President Trump, on the other hand, has made clear his preference for lower rates to reduce the deficit and help the economy grow out of its debt problem. This view is shared across the political spectrum as most policymakers believe lower rates are generally desirable and understand the tradeoff to be the risk of higher inflation. But it’s not true that lower rates are necessarily better for investment and growth; keeping rates too low for too long fuels financialization and reduces the productive capacity of the U.S. economy.
The conventional economic understanding of how interest rates influence the business cycle is incomplete at best. According to that narrative: The Federal Reserve sets short-term interest rates for the economy. When it wants to stimulate growth, it lowers interest rates. Conventional neo-Keynesian theory, on which the Fed’s economic models are based, argues that this effect occurs through the investment component of Gross Domestic Product (GDP). Lower interest rates mean a lower cost of capital for the private sector, which makes companies more likely to deploy capital productively. Their investment causes the economy to grow and the unemployment rate to fall. When the economy starts to run too “hot,” inflation rises. The Fed raises interest rates to make borrowing more expensive. Investment falls, growth slows, inflation comes down.
Or so the theory goes.
Yet over the past 25 years, non-residential investment has shown little correlation with interest rates. The Fed can set short-term rates, but investment cycles are driven primarily by other, more amorphous factors: animal spirits, technology, trade policy, regulation, and so on, all of which are outside the Fed’s purview.
While firms have shown themselves fairly unresponsive to changes in short-term interest rates, one place where the Fed’s policy has a significant impact is asset prices. As a result, when the Fed keeps interest rates too low for too long it encourages debt accumulation, financial engineering, and worsening inequality. It shapes incentives that steer the U.S. economy away from real economic activity and toward financial transactions, and ironically, reduces investment and growth from levels they might reach in a higher interest rate environment.
Federal Reserve Chairman Kevin Warsh has discussed how short-term interest rates might be restrictive for some parts of the economy though not for financial markets. This is a good start. Under his leadership, the Fed should reassess the role that monetary policy has had in increasing financialization, which has made harder the Fed’s goal of maximum employment with stable prices.
A Brief History of Persistently Low Rates and Weak Investment Cycles
The investment portion of GDP can be divided into residential and non-residential components. Non-residential investment—that is, business investment or capital expenditures—has been weakly correlated with interest rates over the past quarter century. This component of GDP is very important to the economy because it expands the country’s capital stock and its productive capacity. Generally, real wage growth has correlated with productivity growth, because more productive workers can demand higher wages. Net domestic investment is the best measure of capital stock growth and has been steadily declining as a share of GDP for decades. It is not surprising that real wages have stagnated.
As American Compass research has shown, recent decades have seen a notable increase in companies that consume fixed capital faster than they make new capital expenditures, even as they return cash to shareholders. This is partly due to the Fed’s interest rate policy.
Since 2000, the Fed has maintained some of the lowest policy rates of all time. Three times it has pushed the nominal interest rate below inflation (and thus pushing the real cost of borrowing below zero): the early 2000s, following the dot-com collapse and the 9/11 attacks; a full decade following the Global Financial Crisis (GFC); and the roughly two years when the nation was dealing with the COVID pandemic. Throughout, the long secular decline in national investment continued. Each instance helps to illustrate, in its own way, why interest rate policy had so little effect.
In 2001, under Chairman Alan Greenspan, the Fed cut interest rates from 6.5% to 1.0%. While the 2001 recession did warrant cuts, Greenspan pushed rates well below inflation because he incorrectly feared a Japanese-style deflationary spiral.
But in the hangover from the dot-com boom, businesses had little appetite for investment regardless of interest rates. With China joining the WTO in 2001, what investment did take place tended to go abroad rather than expand the U.S. capital base.
The effects of the low interest rates spilled instead into asset values and, especially, housing prices—setting in motion events that would eventually lead to the GFC. While lax regulation played an important role, the impact of low interest rates on housing prices and the shift toward adjustable-rate mortgages, a ticking time bomb awaiting eventual rate hikes, were key contributing factors.
The second episode of negative real rates began in 2008 in response to the GFC, when Chairman Ben Bernanke reduced the federal funds rate to zero. This was the correct decision at the moment of crisis, allowing borrowers to refinance debt and avoid widespread default. Yet the Fed kept rates below 1% until June 2017.
Investment in the GFC’s wake was not weak because interest rates were too high, but because the banking system cut lending following its subprime losses. Increased regulation played a role too. Faced with a lack of investment opportunities, companies used the low-rate environment to engage in financial engineering: increasing debt, buying back stock, and conducting mergers and acquisitions rather than making productive investments.
Most recently, the Fed followed a similar playbook in its pandemic response. Rates were cut to zero at a moment of crisis but then held there even as inflation accelerated sharply. By the time the Fed started to raise rates in March 2022, inflation was running at 8%, producing the most negative real rates since the 1970s.
The biggest beneficiary of low rates was the U.S. Treasury, which increased government debt substantially. Once again, low interest rates meant cheap debt, but cheap debt did not mean productive investment; this time, it yielded household transfers that boosted consumption and buoyed the stock market.
Ironically, the U.S. is now experiencing an investment boom despite interest rates being at their highest level in decades. Just as low interest rates failed to drive investment in the face of other factors, high interest rates are failing to suppress it now. This time it is a technological breakthrough, artificial intelligence, calling the shots. But while Fed policymakers are not nearly so powerful as they might wish, the lesson of the past 25 years is that their choices do have major economic and asset price impacts, if not the intended ones, of which they should be far more mindful.
Interest Rates and Debt
Low interest rates encourage debt. From 2000 to 2025, total debt in the United States across households, nonfinancial corporations, and government rose from 185% to 256% of GDP. Debt is not necessarily a problem if it finances productive investments. Households use mortgages to spread the cost of housing over the duration of its use. Firms may borrow to fund projects that generate cash flows sufficient to repay loans and create value for shareholders. Indeed, the 1990s saw stable debt and strong growth, suggesting that borrowing was largely productive. Governments may borrow to fund investment in research or infrastructure that expands the economy and thus the tax base.
Today, however, each additional dollar of borrowing is generating less than a dollar of GDP growth. While the composition of borrowing has shifted—from households in the early 2000s, to corporations in the 2010s, to government in the 2020s—the overall trajectory is one of rising leverage with diminishing returns. And unproductive debt prompts a vicious cycle, in which higher debt levels divert cash flows from investment to interest payments.
Low real interest rates have been a central driver of this trend. In the early 2000s, cheap credit fueled a household borrowing boom that culminated in the housing bubble and subsequent crash. In the post-GFC period, corporations took advantage of low rates to increase leverage, with nonfinancial corporate debt rising from 67% of GDP in 2012 to 77% prior to the pandemic.
This debt was largely used to fund shareholder payouts. By increasing leverage, firms boosted return on equity and achieved higher valuations, as investors seeing a lack of investment opportunities post-GFC rewarded financial engineering over long-term capital formation.
Low rates also fueled a surge in mergers and acquisitions, pumping up the private equity industry and increasing industry concentration. Since the late 1990s, more than three-quarters of U.S. industries have become more concentrated. In parallel, business dynamism declined sharply: the share of employment accounted for by newly formed firms fell by 43% between 1980 and 2016 according to the Federal Reserve.
While concentration has supported corporate profits, consistent with Warren Buffett’s preference for “economic castles protected by unbreachable moats,” it has come at the expense of productivity growth. Research shows that firms in more concentrated industries have higher margins but not necessarily higher productivity.
Corporate spending patterns reflect this shift. In the mid-1990s, S&P 1500 companies allocated less than 3% of market capitalization to shareholder returns and acquisitions and between 3% and 4% to capital expenditures. By 2018, spending on financial activities had risen to 7.9%, while capital expenditures remained in the same range.
In recent years, the primary source of rising debt has been the government. Pandemic-era fiscal programs—including the CARES Act, American Rescue Plan, Infrastructure Investment and Jobs Act, and Inflation Reduction Act—led to unprecedented government borrowing.
Fiscal expansion was enabled by the Fed’s near-zero interest rates and quantitative easing (buying assets from the market). Low rates reinforced the perception that government borrowing carried little cost, encouraging policymakers to prioritize short-term consumption over long-term investment. The result has been a further increase in debt without a commensurate rise in productive capacity.
Interest Rates and Inequality
Another consequence of chronically low interest rates has been elevated asset prices. The low interest rates of the early 2000s caused housing prices to rise substantially. Similarly, the stock market has benefited as investors are willing to pay higher multiples for future cash flows in a lower rate environment. The Fed’s repeated decision to intervene in the market to prop up asset prices has led investors to believe they are protected from downside risk.
High asset prices are not a problem if their growth follows the economy’s. But after holding steady below 400% of GDP during the second half of the 20th century, U.S. household wealth surged to almost 600% in the 2020s. Rising wealth has exacerbated income inequality and gains have been concentrated among older households—particularly the Baby Boom generation, which holds roughly half of U.S. wealth.
Rather than channeling these gains into productive investment, this cohort has largely used wealth to sustain consumption, particularly in sectors such as healthcare and housing. At the same time, rising inequality has increased barriers to upward mobility. Education, traditionally a pathway to higher income, has become significantly more expensive, reflecting both increased demand and the higher opportunity cost of remaining outside the top income brackets.
The Dollar, Capital Flows, and Deindustrialization
Even though interest rates were low during much of the 2010s, the dollar strengthened as U.S. markets outperformed others around the world, attracting inflows of foreign capital .
A self-reinforcing loop emerged: rising U.S. asset prices attracted capital inflows, which strengthened the dollar. Countries with relatively weaker currencies were able to generate trade surpluses, which they recycled into U.S. assets, driving asset prices even higher.
But while Wall Street reaped enormous profits from this dynamic, a stronger dollar has significant consequences for Main Street as well. A stronger dollar makes exports more expensive, reducing the competitiveness of U.S. manufacturing and frustrating efforts at reshoring. Instead, firms have an incentive to offshore production to lower-cost regions, contributing to deindustrialization and lower investment.
The Fed’s Path from Here
Why did the Fed keep interest rates so low, even when doing so failed to deliver the investment effects that its models predicted? The central bank has a dual mandate to pursue maximum employment consistent with stable prices. In standard economics, the main risk from low interest rates is an overheating economy that generates inflation. For much of the 2000s, inflation was below the Fed’s target, so it could focus on the employment side of the mandate.
However, full employment with stable prices and rising wages requires capital formation to make the workforce more productive. Robust investment has other invaluable benefits as well. The pandemic exposed the consequences of a degraded U.S. industrial base and weak U.S. supply in turn magnified COVID’s impact on inflation. To its credit, the Fed responded decisively, if belatedly, by raising rates in 2022–23. But now, as inflation moves closer to target, the conversation has followed its traditional pattern back to when rates could be cut further.
The question on everyone’s mind is whether rates are too “restrictive” of investment, the assumption being that higher rates are more restrictive. But the last few decades have shown that interest rates suppress investment when they are too high or too low.
The Fed needs to consider a more nuanced set of tradeoffs. On one hand, the AI-driven capital investment cycle has the potential to deliver strong growth, full employment and disinflation.
On the other, we are already seeing signs of rapid asset price appreciation and unsustainable debt accumulation. Asset prices relative to GDP are setting new highs and consumption is increasingly dependent on a buoyant stock market. Interest rates have not restricted government borrowing or worsening debt dynamics in the corporate sector. Higher rates won’t necessarily create a drag on the kind of investment the economy needs. To the contrary, they may promote that investment by squeezing the unproductive financial engineering activities of which we need far less.
The Ghost of Jude Wanniski replies:
Well now, Mr. Khurana has written a thoughtful piece, and he deserves credit for seeing what the Fed's own economists refuse to see: that the neo-Keynesian model, in which the interest rate is a dial the central bank turns to summon or suppress investment, simply does not match the facts of the last twenty-five years. He shows the correlation isn't there. Good for him. But having broken free of one error, he walks straight into another — he still thinks the interest rate is the main character in this story. It isn't. It's a bit player. The dollar itself is the main character, and nobody in this piece asks what the dollar is actually worth.
Let's go back to fundamentals, the ones this profession abandoned two generations ago.
Say taught us that production is the source of demand — a man works, and in working, creates the means by which he buys what someone else has made. Investment is not called into being by cheap credit; it is called into being by the expectation of an after-tax return on production. That's why Mr. Khurana's own data shows no correlation between rates and investment. Businessmen don't lie awake at night wondering if the federal funds rate is 1 percent or 5 percent. They lie awake wondering whether what they build will be worth more than what it cost — after the tax man and the inflation man have both had their say. Change the incentive to produce — through tax rates, through regulation, through the certainty of the currency you'll be paid in — and you change investment. Fiddle with the interbank lending rate and you change very little except who gets rich playing games with paper.
That brings us to Aristotle, who understood something the modern central banker has forgotten: money's whole purpose is to be a stable measure, a common denominator that lets a shoemaker and a farmer trade fairly. Aristotle also warned about chrematistics — the pursuit of money for its own sake, detached from the production of real goods. What does the Fed's stop-and-go policy over the last twenty-five years actually do? It makes the dollar an unreliable ruler. And when the ruler itself keeps stretching and shrinking, nobody wants to build a house with it — they'd rather trade the ruler. That, gentlemen, is financialization. It isn't caused by the price of credit being too low. It's caused by the value of the dollar being too uncertain. A merchant who doesn't know what his money will be worth in five years won't plant an orchard; he'll flip a stock.
Now to Ricardo, because there's a piece of mercantilist nostalgia buried in this essay — the notion that a strong dollar "hurts Main Street" by pricing out exports, and that a weaker dollar would bring manufacturing home. Ricardo settled this two centuries ago. Nations don't get rich by cheapening their currency to sell more abroad; they get rich by producing what they're best at and trading for the rest. A strong dollar is not America's curse — it is the world's vote of confidence in American production, and the proper response to deindustrialization is not currency debasement, it's removing the tax and regulatory penalties on domestic capital formation. Chase a weak dollar and you'll get Argentina's manufacturing base, not Germany's.
And Friedman — who I sparred with plenty in my day, mostly over whether the Fed should target the money supply or the price of gold — would still agree on this much: inflation, and its opposite, deflation, are monetary phenomena, not interest-rate phenomena. The author keeps conflating "the price of money" (the interest rate) with "the value of money" (what a dollar actually buys). These are not the same thing, and the Fed's whole tragicomedy since 2000 comes from treating them as if they were. You can hold rates near zero with a stable dollar, and you can hold rates at ten percent with a collapsing one. The rate is not the disease or the cure. It's a symptom.
So what would I tell Mr. Khurana? Don't ask the Fed to raise rates to "discipline" Wall Street — that's still the old central-planning impulse in a new suit, still the notion that some committee in Washington can find the one true price of credit that will make Americans build factories instead of buybacks. Ask instead that the Fed do the one job classical economics assigns it: keep the measuring rod fixed. Anchor the dollar — to gold, if you want a rule nobody in Washington can talk himself out of — and then get out of the business of setting rates altogether. Let the market, not the FOMC, decide what savers are paid and borrowers owe. Pair that with lower marginal rates on capital, the Laffer lesson this magazine's other writers understand well enough, and you'll get the productive investment boom the postwar Fed promised and never delivered.
The rate was never the problem. The ruler was.
Great article Brij your spot on. Thanks.
Only a few items would I mention to clarify from my readings and take. You said, "Greenspan pushed rates well below inflation because he incorrectly feared a Japanese-style deflationary spiral."
I have read and believe that Greensapn lost control of interest rates due to Asian and primarily Chinese buying treasuries to lower their currency and to launder their surplus money. He said to Congress it was a "conundrum"? So, he didn't know what was happening or at least said that? Strange? Biggest reason the housing market went off the rails.
Alos, he many times kept saying adjustable-rate mortgages are great and a great new tool for the housing market?! What? really? and from a guy who never bought a house but always rented? How would he know right? lol funny
Warren Buffett’s preference for “economic castles protected by unbreachable moats,” ok Brij let's call a spade a spade. Monopolies. Monopolies were legalized and as Buffet said that's what he looked for and bought of course! lol Monopolies are poison just like socialism and communism is poison. Just the other side of the barbell. They reduce competition and kill markets like communism does. Monopolies were allowed again in the 1970's because they were more efficient? ok whatever.
Hey excellent write up thank you again.