How Low Interest Rates Are Impacting on Monetary Policy

Tackling the Hard Issues: Near-Zero Interest Rates and Monetary Policy…..

Central banks are at a crossroads: they have slashed interest rates to near-zero levels around the world in response to a dramatic slowdown in the global economy. Rate reductions are evident across the board, with the federal funds rate (FFR) at 0.25% – 0.50%, the bank rate in the UK at 0.25%, and 0.000% in Europe. In fact, a snapshot of central bank interest rates around the world makes for grim reading if you are looking to invest your money in fixed-interest-bearing accounts. The Bank of Canada has fixed the interest-rate at 0.500%, while the People’s Bank of China (PBOC) has the interest-rate pegged at 4.350%. As the world’s second-largest economic bloc, the euro area effectively has an interest rate of 0%.

This becomes especially troubling if a recession starts biting in the European economy. Central banks typically use interest rates to manipulate monetary policy by stimulating spending or encouraging saving. When interest rates are high, or raised, there is a greater propensity for foreign investors to buy up that country’s currency and invest in fixed-interest-bearing accounts. It also encourages high levels of domestic saving. The net effect of a high interest rate is a decreased monetary supply. On the other hand, when interest rates are low or being lowered, the money supply increases. The reason for this is simple: low rates of interest are conducive to high rates of investment, expansion of credit facilities, spending and rising inflation. In other words, when central banks want to stimulate the economy, they drop the interest-rate.

Does Monetary Policy Work?

There are arguments for and against the effectiveness of monetary policy. In truth, the current global economic climate is highly complex. A mix of monetary policy and fiscal policy is required to grow the economy. Monetary policy is focused on bond buying (corporate and government bond purchases) and interest-rate manipulation. If central banks want to stimulate the economy, they can buy up government bonds. This is exactly what has been happening with the ECB, the BOJ and the BOE. Recall that the Bank of England recently increased its quantitative easing to the tune of £70 billion. This was comprised of £60 billion in government bond purchases and £10 billion in corporate bond purchases.

When demand for government bonds increases, the price of those bonds increases and the yield plunges. We are now in an era where it is no longer viable to purchase government bonds because the yields are either negative, or substantially less and you can get by holding alternative assets in your financial portfolio such as gold. The price of gold is hovering around $1,350 per ounce (up 26% for the year). This is being driven by uncertainty about Fed policy (raising interest rates or not in 2016?), overvalued indices on Wall Street which appear to be at the tipping point, and a weakening USD.

What is Likely to Happen with Interest Rates in the Global Economy?

This question is possibly best answered by another question: How long is a piece of string? The answer is not as clear-cut as one may assume. The complexity of monetary policy and ongoing debates about its effectiveness have raised doubts about how much central banks can do to stimulate economic growth. We are now flirting with the idea of negative interest rates, and this was highlighted when the governor of the Bank of Japan surprised economists by slashing interest rates further. While the Bank of England does not believe that negative interest rates are a viable tool for the UK economy, who is to say that they won’t move in that direction?

Negative interest rates effectively place a cost on banks for parking their money with the central bank. This means that the commercial banks will have to find inventive ways of storing stockpiles of cash if they so desire. The objective of negative interest rates is to encourage banks to loan money to stimulate economic growth. However, there is no conclusive evidence that supports the theory that negative interest rates are good for economic growth in any way. In fact, there is evidence that points in the other direction. Banks rely on short-term deposits and generate profits off long-term loans. The difference between interest-rate is how banks earn their money. We are entering dangerous waters when deposit rates are higher than lending rates – the entire economic model is upended.

A Meeting of the Minds is Needed to Thrash Out Effective Monetary Policy Approaches

In Japan for example there is a general understanding that the corporate sector and the private sector benefit from negative interest rates while the banking sector may be taking a hit. That may work in Japan at least on paper, but the reality is somewhat different. Savers will suffer, and even if there is very little savings to be had given the poor economic climate, saving is a pre-requisite for capital consumption. We have highly unresponsive corporate investment and private investment, despite low borrowing costs.

Fortunately, there are many programs in effect which mitigate the negative aspects of low interest rates such as the term funding scheme by the Bank of England and the longer-term refinancing operations of the ECB. What is an irrefutable fact at this time is that conventional wisdom about interest rates no longer applies, and a radical rethink of monetary policy vis-a-vis interest rates is needed. The post-Brexit era and a recessionary global economy are evidence enough of the need for an ‘indaba’ of the monetary policy authorities.