Saturday, December 20, 2008

What Will Happen If Interest Rates Fall To 0%

Base rates in UK as in December 2008: 2% (lowest since 1951)

US base rates: 0%-0.25% (the lowest since 1954)

It is ‘interesting’ to see how US government & the Fed react to the economic doldrums in States since they are the main causal of all this mess around the world. The experience, skills & wisdom of policymakers are tested once again, after an economic slowdown short after the 9/11 event.

Recently, one of the boldest move taken by the Fed is slashing the key rates to as low as between 0% - 0.25%, a level lower than in 2002. Having said so, one should not be misled to think that now firms & consumers can go to banks on high streets & borrow money to expand business, acquire capital goods or buy property for FREE

What this means is that, commercial banks itself can borrow money from Fed for a very limited period of time without paying much interest as before. But since it is standing at such low level, from practical point of view whether it is 0.1% or even 0% doesn’t matter anyway

What do 0% interest rates mean?

(1) Carry trade activities. The most famous event is yen carry trade. It happens throughout the long lost decade in Japan, in 1990s where interest rates were held at 0% up to last year where interest rates are still very low at 0.5%. It is a situation where borrowers or investors taking advantage by borrowing cheaply in yen to save or invest in countries that yield much higher interest rates such as Euro, UK or even in US. If the exchange rate is stable they could easily profit 4% to 5% after deducting all those transaction fee. Perhaps this could happen to America, if the situations in States worsen while Eurozone begins to show sign of recovery & other emerging economies remain robust

(2) Traditional monetary policy has come to an end.
Monetary policy has always been an effective tool to combat inflation, to manipulate how people & firms spend, managing the exchange rate, prevent unemployment rate etc. In period of rising property prices such as early 2000s to mid 2000s in both UK & US, interest rates were raised to cool down the economy. In US it went up to 5.25% while in UK 5.75% before coming down. But in period of downturn, rates will be aggressively adjusted downwards to prevent deflation. Now it is standing at 2% in UK & I believe that it will go down further in coming months. In US, it makes not much difference by saying that now it’s at 0%. Therefore we say, traditional monetary policy tool can no longer boost the economy. It runs out of ammo

(3) Quantitative easing. The Fed will have to turn to unconventional tools like quantitative easing. This means an attempt to increase money supply in circulation, hoping that it will encourage greater lending & greater economic activity over time. In modern terms it is equivalent to printing more money. What the Fed will do is buying up all those government bonds or debts & mortgage backed securities issued by Freddie Mac & Fannie Mae. This is somewhat similar to Japan’s effort to combat deflation. Increase in money supply, will always ensure that the interest rates are kept low. Although some economists argued that this will lead to inflation or even hyperinflation, it is not much of our concern now. My argument is that velocity of circulation had fallen steadily. Second, the threat of deflation is seems to be the more realistic picture due to fast contracting economy

(4) Difficult to generate lending. One of the methods for commercial banks to generate lending is by using depositors’ saving. In fact one of the causal for the financial crisis is due to low savings ratio among Americans & Britons, which force banks to seek funding from money market. But given the interest rate is virtually 0%, in theory, banks saving will fall & as such again banks may find itself difficult to generate lending. However this may not be the case. The US & UK government had pumped lots of money into the financial system to increase liquidity. Besides, although base rate is at 0%, banks will likely keep savings & lending rate above 0% to attract depositors. As such the fall in lending rates is not so much of banks’ inability to do so, but rather their stubbornness to improve the balance sheet & recap some of the earlier losses

(5) Greenspan-Bernanke legacy. Economists blame Greenspan for all these financial mess. It was his policy to keep Fed rates as low as 1.25% in the early 2000s which lead to an era of cheap borrowing, which saw leap in house prices. The problem was aggravated by banks’ generosity to lend money even to lousy paymasters & people with irregular jobs. That time, they were too optimistic that the inability to serve repayments will be offset by the rising value of their houses. In short, all comes from a long period with low interest rates. Now, Bernanke seems to be of similar interest to Greenspan. In the medium term, will we witness another credit bubble burst? Will it help US to realise its dream to become an empire of huge debt due to another round of bailout & massacre spending? The next Fed reserve chairman will have to address these

(6) Deflation is almost inevitable. In general, hardly we hear any central banks decision to cut interest rates to even 1%, what’s more at near 0%. This is a sign that those policymakers are desperate since the economy is fast dying, threat of recession is stumbling in & period of deflation is almost imminent. One may think that since inflation-the period of sustained increase in price level is bad since it erodes our purchasing power, then what’s wrong with falling prices? Well, answer is no either! In period of deflation where prices continue to fall, people will postpone spending as they expect future prices will be cheaper. When everyone thinks the same, consumption & investment will be very low. This will pose a threat to major developed economies which are mostly consumption driven. Nearly 70% of US & UK’s GDP consists of private consumption

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