Are low interest rates good for our economies?

by Dec 15, 2016

Interest Rates

Ultra-low interest rates were first deployed in major economies in 2009, and they were viewed as temporary policies to dig us out of the hole (created by the financial crisis.) Now these policies are taken as a semi-permanent feature.

How did we get here?

After the financial crisis in 2008, global financial markets were subdued, ushering in a new era of economic uncertainty. As the full scale of the long term effects became clear, central banks and their role of deciding monetary policy took a bigger role, as investors looked to them to provide stability and try to predict whether there were more storms ahead. The natural reaction was to reduce interest rates and cushion the world’s economy which was hugely damaged, and this they did, maintaining rates at record lows for years, paralyzed by factors like stagnant economic growth and high unemployment figures.

Janet Yellen and Mario Draghi. The worlds two foremost central bankers.

Never before in economic history have interest rates been so low, for so long. This had knock on effects by not only reducing the amount savers can earn on their deposits, but also making investors look further afield for yield. On one hand the cost of borrowing is down, but on the other incentives to lend are less, meaning we keep going round in circles. This has been noted by many. In September 2016, the former banker turned author and academic Satyajit Das wrote: “Central bankers since 2008 have sought to use low interest rates to boost global economic growth and increase inflation in order to bring elevated debt levels under control. Low rates are supposed to encourage debt-financed consumption and investment, feeding a virtuous cycle of expansion. They also increase wealth, encouraging spending. Low rates and abundant liquidity should drive inflation. Instead, these policies since 2008 have brought the global economy a precarious stability at best, and have not created economic growth or inflation.” He argues, “Such financial manipulation will ultimately reach its limit, with catastrophic consequences. The reality is that current policies if continued make this inevitable. What form it will take, and when, is unknown.”

What about the future?

Das also argues that we may see central banks including the Bank of England setting negative interest rates in the longer term, but BoE Governor Mark Carney said he does not envisage this happening.

Today, even a slight uptick in rates is huge news (as we have seen from the Federal Reserve in December 2016). To put this into context, the Fed has only raised rates twice since 2008, so when they do hike, (even by a tiny fraction as they did in December) it’s a widely debated topic, as policy makers and investors want to know what central banks think of the state of the global economy. The two graphs below (taken from Reuters and the Bank of England) gives some context to just how low interest rates have gone in the UK, US and EU compared to historic levels pre-crisis.

In 2016, a notable contrast can be seen when comparing the Fed’s policies to the ECB’s at the end of this year, highlighting the disparity between the European and American economies. The Fed raised rates and was ‘hawkish’ (meaning aggressive and strong) about growth in 2017 as well, predicting that it would raise rates again, possibly several times. In Europe, no dice. The ECB kept interest rates the same again and said it would continue its bond purchase programme well into 2017 (meaning that it doesn’t feel as optimistic about Europe’s recovery).

This seems prudent, given the massive uncertainty surrounding Brexit, the woes of Italy’s banking system and the rise of right wing nationalist parties which threaten the European Union. However, though it seemed sensible, the decision has left people wondering just how long this strategy can be employed before the central bank can no longer buy up bonds and before it reaches the limits of monetary policy.

Are low interest rates helping us?

It may be true that low interest rates have maintained stability. For some countries this has kept them on an even keel at the moment while policy makers are concerned with short-term firefighting. In the longer term however, current policies are discouraging long-term saving, while businesses are being forced to divert resources away from productive investment to support ailing pension funds.

The simple fact is that low interest rates are not good for savers. You can see that in the way that people used to look more towards investing in bond’s to provide better returns and protect against inflation. But in a low rate environment, that’s no longer the case. If people don’t want to save, this has negative knock on effects throughout the economy.

Central bank’s powers are limited. They mainly respond to what is happening in the economy and try to steer the ship in the right direction, and given deflationary pressures on the global economy it’s hard to see any alternative to low rates for the time being.

What does invstr think of this long period of low interest rates? Our CEO Kerim Derhalli said: “Since the financial crisis of 2008, Central banks globally have pursued a policy of ultra-low interest rates to revive growth. Creating artificial prices for borrowing money distorts the risk-free rate and potentially disrupts investment in the real world. A number of questions arise in respect of this unprecedented policy: was this the most suitable response to the crisis? What other solutions could we have adopted? What are the unintended consequences of the ultra-low interest rate policy? We may find in time that the extended duration of quantitative easing did more harm than good to the global economy.”

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