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.
