What’s the point in low interest rates?

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It’s the simplest of all policies. If a central banker wishes to stimulate an economy – they cut the central bank base interest rate. If they wish to moderate it – they raise the rate. The classical theory being that manipulating the rate alters the cost of credit and thus encourages/hampers individuals and firms spending incentives accordingly.

As we can see from the charts above, developed economies have maintained persistently low interest rates ever since 2008 and the Global Financial Crisis (and in Japan’s case, a lot longer…). The central banks have been attempting to gee up economies with cheap credit, exactly as the theory advises. However, as has been seen in the years subsequent – economic growth in each of the same economies has been relatively anaemic in spite of the historically low interest rates.

Thus this post will investigate the channels that interest rates are supposed to affect the economy – looking how it is supposed to affect both individuals and firms. Although it is an elementary discussion, its apparent ineffectiveness in recent years highlights that an assessment is a worthy exercise.

How is it supposed to work?

As briefly described above, classical monetary policy suggests that adjusting the central bank base rate accordingly impacts open market interest rates, and simply changes the price of credit. Borrowers react to the change in price of credit by subsequently expanding or reducing their demand for loans – and thus their spending.

However alternative theories emphasise parallel channels that may explain how adjusting interest rates may impact economies. Firstly, there is the Balance Sheet Channel – whereby alterations in interest rates impact actors’ balance sheet figures and income statements. An increase in the interest rate increases the “profit” that individuals receive on their savings and incomes – which enables them to increase their spending in the economy. On a national level, this alters aggregate demand (and thus GDP).

Secondly there is the Bank Lending Channel, which observes that reducing the central bank base rate not only reduces the price of credit – it also increases the availability of credit in the economy. Reducing the interest rate reduces the “profit” of holding on to funds in banks by savers and other institutions – thus these funds are released into the financial system and increase the aggregate loanable funds in the economy. Once exposed to this increase in funds, the lending institutions repurpose the money and release new loans to the public (also probably at a reduced rate) – thus prompting an expansion of national spending and thus GDP.

Problems

However there are a number of problems that question the validity and impact of interest rate adjustment on an economy. For example, any alteration in interest rates can only feasibly have a severely time-lagged impact on the economy. This is as there are multiple layers that the event must permeate before spending decisions (and thus the economy) is affected. That being the case, it is hard to analyse and therefore prove that it was the alteration in interest rates that generated the resultant situation. Similarly, not all economic parties are affected simultaneously: e.g. individuals with existing loans-vs-individuals looking for new loans, residential loans-vs-commercial investments, consumer durable spending-vs-short-term entertainment spending. Hence the measurement issue becomes multiplied and the contradictory impulses generated in these segments may cancel out the overall intent of the original change in interest rates.

Moving to the internal issues with the theory – there is no guarantee that any change in base-rates will be carried forward by financial institutions to be reflected in open market interest rates. If banks manipulate or delay the transference, the policy impact may become neutered. Meanwhile, monetary policy interventions cannot be treated in isolation. The preceding economic period (e.g. low rate for many years, long-term preceding recession, years of high profits, etc.) impacts whether or not economic actors will actually act upon the alteration of interest rates as planned. Consider the US economy before and after Autumn 2008: with a long preceding period of low interest rates and record levels of debt, the reduction in interest rates in reaction to the Global Financial Crisis had little stimulative effect. Which leads to another issue with the presumptive impact of interest rates – economic actors have to believe that the central bank policy is “genuine”. That is – low interest rates have been employed to stimulate the economy, or increasing interest rates have been engaged to temper it. And thus there will be re-enforcement of the policy over future time periods. If economic actors do not believe this to be the case, they will fail to act as desired – and influence the economy in the long run.

Conclusion

The long-run impact of interest rate alterations have long been a mainstay in the central banker’s tool box. However it is clear that practically, the successful impact of any policy alteration is far from certain.

© Patrick Tsui and liminaleconomics.wordpress.com, 2015. Unauthorized use and/or duplication of this material without express and written permission from this blog’s author and/or owner is strictly prohibited. Excerpts and links may be used, provided that full and clear credit is given to Patrick Tsui and liminaleconomics.wordpress.com with appropriate and specific direction to the original content.

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