Thursday, December 18, 2008

Zero 0% Interest Rates

In the US, 3 month Treasury Bills have started attracting a negative interest rate. What this means is that people are willing to pay the US government the privilege of holding their cash. It reflects the deep concern that people have about saving in private banks. It is examples such as this which caused Warren Buffet to quip that mattresses could be the best thing to invest in 2009 - because people will want mattresses to horde their cash in.

The rush for cash is one reason why the dollar has been unexpectedly strong this year. The dollar is widely looked upon as an alternative currency, so when people demand more cash, they often demand more dollars. Therefore, despite 0% interest rates in the US, the dollar has been relatively strong.

The Effect of 0% Interest rates

  • Monetary Policy becomes ineffective. Generally, you can't cut interest rates lower than 0%. It means that with 0% interest rates, the MPC are not able to cut interest rates any further to boost the economy. Conventional monetary policy has reached the end of its potential.
  • Unconventional Monetary Policy. If the economy experiences deflation and interest rates are 0%, then the monetary authorities may be forced to take unusual steps such as increasing the money supply. To highlight the unconventional nature of 'quantitative easing' Ben Bernacke highlighted the idea of dropping money from a helicopter. The point is that increasing the money supply may be necessary to overcome deflation and deflationary expectations.
  • Carry Trade. When Japan had 0% interest rates and other countries had significantly higher interest rates, there was an incentive to take part in the Yen Carry Trade. This involved borrowing from Japanese banks at 0% and then saving in other countries. If exchange rates were stable, you could make an easy profit. - Borrow at -0% save at 4%. However, the fall in interest rates is a global phenomenon, it won't just be one country which is affected. However, it will be interesting to see whether the ECB are willing to cut rates to 0% - given their anti inflationary bias.
  • Base Rates and Saving Rates. If bank rates fell to 0%, there could be a big fall in bank savings. But, although, base rates may be 0%. Banks are likely to keep saving and lending rates above 0%
Real Interest rates.

The impact of 0% interest rates will depend on the inflation rate. If inflation stays positive e.g. 2%, then we will have negative real interest rates. This will be bad for savers. If we have deflation, then real interest rates will be high, although this will be good for savers it will be very damaging for the economy.

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