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Low interest rate regime: The sign of the time

Muhammad Mahmood | Saturday, 7 December 2019


At this point in time, wherever one looks at the global economy, signs of economic slowdown is pretty visible. In fact, most advanced economies are not only trapped in a low interest rate regime but also low growth cycle. Until recently most central banks in these countries talked up raising interest rates from near zero  to negative range to a more upward positive range. But that is not the case anymore. The US Federal Reserve (Fed) and the European Central Bank (ECB) have cut the rate in the very recent times and more may be forthcoming before the year end. The Federal Reserve considers the current US economic growth performance as moderate not solid. This along with slowdown in global growth, declining business confidence and rising risk perception in financial markets as reflected in the fall in yield on long-term bonds in the US and other advanced economies will be factored in to see how they weigh in on the economic outlook in making a decision on the interest cut in the US. But now what they all see rather strengthen the case for an interest rate cut in most advanced economies.

The ECB also decided to hold onto its policy of interest rate (now in the negative range) until "at least through the end of 2019'.  The former ECB Chairman Mario Draghi  announced a monetary expansion amounting €2.6 trillion (QE). That immediately caused the euro to depreciate against the dollar and lifted the European share market attracting furious response from Trump. But Mr Draghi said he was meeting the ECB mandate to lifting the inflation rate close to but below 2.0 per cent.

Japan's long-term interest has also fallen into negative zone and in Australia the Reserve Bank of Australia cut its interest by 0.25 percentage point to 0.75 per cent.

But the role of dollar as the international currency limits the efficacy of monetary policy in other countries, indeed the US Federal Reserve's actions can have profound impact on the effectiveness of monetary policies in other countries. The global financial markets are largely dominated by dollar-denominated bonds at financial and non-financial institutions outside the USA. Also, a very large number of private actors in the global market finance their activities in dollars. As a consequence any monetary easing in the US will have a direct bearing on the global economy and financial markets.

 The global economy is slowing down resulting from various economic shocks, turbulence in emerging markets, economic slowdown in China and weakening domestic demand in developed industrialised countries which in turn has been  caused by very  low to no real  wage growth. The prolonged very low rates of interest started in the wake of the Global Financial Crisis (GFC) of 2007-2008 and continuing. The explanation for the phenomenon lies in persistently low inflation which enables central banks to keep interest rate down.

Since the 1980s central banks have been dominant players in to the use of monetary policy to bring down inflation quite substantially and also that enabled  developed countries  to weather through the major impacts of the GFC. Also, another corollary of low interest rates is currency depreciation, enabling countries to export more and import less. But when that happens simultaneously across all developed countries, nothing really changes. Currency depreciation can have desired effect of boosting exports only when there is a relative fall in the exchange rate. If the short and long-term interest rates are already at the rock bottom level and can not fall any further as now in Switzerland, Denmark, Sweden, the EU and Japan, it is impossible to bring about any relative changes in the exchange rate through the interest  rate mechanism.

Throughout history it has been the considered opinion that central banks could not move short-term interest rate below zero to the negative range. The zero interest rate was seen as the lowest point an interest rate could go down and at that point central banks would run out of any option open to them. But that is not the case any more. Since 2012, central banks in Denmark and several other European countries and Japan have gone below the zero interest rate - and so also the  European Central Bank. It now appears the ECB and Bank of Japan (BoJ) may even double down and print more money and lower interests further. Such an interest rate policy by central banks indicates that there is no limit how far down the interest rate can go. While such a policy of setting interest rates below zero is quite unconventional, this is, from a central bank's point of view, just the continuation of the normal monetary policy,  deploying the short-term interest rate instrument to respond to economic fluctuations.

The central issue is the real interest rate. But when we mention the interest rate, usually it is nominal interest rate. The real interest is when the nominal interest rate is adjusted for inflation. A country with both positive interest rate and a higher inflation rate can experience zero to negative short-term interest rates. On the contrary, a country with  very low to negative interest rates but with a negative inflation rate can experience a positive interest rate outcome. Overall, the inflation rate is very low in all developed economies; even it went down negative in Switzerland enabling central banks to lower interest rates and venturing into the negative zone which so far also has not impacted negatively on private bank deposits or triggered increased demand for cash.

Since the GFC of 2007-08, all developed economies have been experiencing very low growth and also low levels of inflation and investment. Under the spell of neo-liberal economic policy orientation all these countries have been relying on using  largely the single most potent monetary policy instrument, the interest rate, to stimulate economic activity and spur inflation which is very low by historical record. In fact, developed countries are now  in fear of sliding into deflation. Now that the interest rate has come down close to zero to negative interest rate zone, such a very low interest rate regime to stimulate economic activity has been premised upon a number of assumptions such as it would encourage consumption and investment and discourage savings and also cause currency depreciation which would then decrease demand for imports.

But such a bold and unconventional monetary policy initiative has not yielded the desired outcome. It did not stimulate consumption and investment. The reasons are many and varied and some are the result of the low interest rates policy itself. Such a policy has now created its own logic where it is likely that it will be very difficult to move away from such very low interest rate policy. The consequence of such a policy is that quantitative easing (QE) will also continue creating abundant supply of cheap money. This will lead to build-up of further debt burden with significant potentials for destabilising the financial system again. This will also work against any needed structural adjustment in the economy adding to further slowdown of the economy, thus getting stuck in a low-growth equilibrium trap. Many argue that with interest rates stuck at close to zero to the negative range, monetary policy is now largely ineffective and fiscal policy will need to take up the reins to manage demand.

Muhammad Mahmood is an independent economic and political analyst.

muhammad.mahmood47@gmail.com