The Effects of Reducing Interest Rates

Written by: Anisah Khan

Many countries around the world are currently in a state of emergency due to the global public health crisis caused by Covid-19. Governments and central banks have all responded in varying ways to limit the effect this has on economic growth.

In the US, on March 3rd the Fed cut interest rates initially, and then again on the 15th of March bringing it down to zero. An array of other measures was announced to aid economic stimulus, including quantitative easing to increase liquidity in the flow of capital markets. Alongside this, actions not seen even in the 2008 financial crisis have been committed to, such as introducing open-ended ‘bridge financing’ lending money to companies struggling during this time. Through this, the Fed is hoping to curb unemployment and cash flow issues stopping firms becoming insolvent.

In the UK, on March 20th the new Chancellor Rishi Sunak revealed unprecedented measures to keep Britain’s economy afloat. These included interest-free grants to small businesses, deferral of tax deadlines, and paying up to 80% of wages amongst others. The Bank of England cut interest rates from 0.75% to 0.25% and then further nearing zero to 0.1% on March 19th – the lowest level in the Bank’s 325-year history.

WHAT DO LOWER INTEREST RATES ACHIEVE?

Reducing interest rates is a way to stimulate economic growth through many ways.

SAVINGS

When inhabitants of a country choose to save money, spending is reduced which stagnates economic growth. In order combat this and entice consumers to adopt a behaviour where they spend rather than save, reducing interest rates will cause a reduction in savings and therefore more spending will grow the economy. In the UK, we are typically a nation of spenders, however retired citizens may be opposed to a reduced interest rate as they are likely to rely on savings as their main source of income, thus lower disposable income will result in them spending less.

However, a lower interest rate will only make a difference to regular consumers if banks also reduce the rates and pass the cut onto customers. In the 2008 financial crisis, banks did not follow through as they were more concerned about boosting their own bank deposits; lowering interest rates would have stagnated their own revenue. The availability of items such as mortgages was limited, as the banks were reluctant to lend after the crash which meant customers were unable to spend.

Alongside this, another conflict may arise if consumer confidence is low. A general lower confidence in the economy will mean that some consumers may choose to save money rather than spend, despite the lower interest rates and fall in value of savings. After 2008 credit crunch, the savings ratio was increased as more people were cautious and felt they were better placed financially if they saved money rather than spend or borrow.

BORROWING COSTS

Lower costs of borrowing is achieved through a reduction in interest rates. This acts as an incentive to businesses to continue investing and expanding as financing is cheaper and easier to obtain. Consequently, employment levels should not drop during difficult financial periods as through better cash flows, companies will not be under pressure to make staff redundant, instead hiring more people in expansion. Unemployment causes many issues for the economy as it is an inefficient use of labour as a resource and a loss of human capital will result in lower tax revenue and higher Government borrowing. Unemployment can also cause many negative social aspects and greater disruption to an individual’s wellbeing and society.

Asset prices, such as housing can rise due to the more attractive financing options to buyers. This will in turn, increase confidence through a perceived wealth effect and aid the economy to grow further. With lower borrowing costs, mortgage payments are reduced causing an increase in spending as borrowers have more disposable income to use. It is important to consider the timing in this case, as many borrowers may be fixed into a longer-term deal, such as a two-year fixed mortgage deal. Thus, the effect of lower interest rates will not come into effect for them until the contract reaches maturity.

EXCHANGE RATES/EXPORTS V IMPORTS

When interest rates are dropped, saving in the UK is less attractive which therefore depreciates the value of the Pound Sterling. Aggregate demand – total spending on goods and services – is increased as the devalued currency makes exports more competitive and imports more expensive. This results in a growth in economy as spending increases. Nonetheless, other factors may cause this scenario to not pan out in this way. If there is a strain on the global economy, such as in this pandemic, export demand will also decrease which is likely to offset the increase in spending.

FURTHER FACTORS TO CONSIDER

After the Fed’s announcement, stock prices rose globally with lower US rates making the stocks more appealing to investors. However, whether pre-emptive monetary policy action will prove to fully protect against the damage to the economy from the virus has been debated. Some critics suggest that it is the job of Congress to secure economic aid through fiscal stimulus. While lowering interest rates may aid economic growth, with signals of a looming recession appearing including an inverted yield curve, an already low interest rate may prove to have an adverse effect if a crisis does occur. Reducing interest rates further than it already is could backfire by taking them into the negatives, making quantitative easing by central banks adding to the money supply as a monetary measure during a recession an unhelpful option. It is not solely a lack of liquidity overall, but a halt in trading due to public health restrictions that is the issue in this crisis. Governments may be pressured to influence economic growth through fiscal stimulus activities such as infrastructure spending and tax cuts. This has been seen in the current climate, with many Governments globally introducing unprecedented fiscal stimulus measures, alongside the monetary policies implemented by central banks. Together, the two can act in tandem; monetary as a foundation and fiscal as a safety net to limit widespread economic damage and restart the economy in the coming months.

Moreover, interest rate cuts are unlikely to make a large difference in countries with already low rates such as in the Eurozone. If supply chains are interrupted and consumer spending plummets with less people travelling and more stockpiling and staying at home, Coronavirus fears will overtake the attempts to stimulate the economy.

In order to overcome the impact on the economy, actions taken by Governments such as wage pay-outs and short-term finance to companies including SME’s affected by Coronavirus will limit the disruption and aid firms to keep operating to some degree during this crisis, eliminating cash flow issues and potentially avoidable liquidations and bankruptcies. This will also encourage companies to keep staff, reducing unemployment levels and strengthening the economy further in the long run.

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