Monday, February 16, 2009

0% Interest Rates Japan + UK

Readers Question: What effect would a long period of very low or zero interest rates have on savers, borrowers and financial businesses in the US and UK?

I’ve read a bit about what happened in Japan in the 90s, but despite zero interest rates, Japanese saving levels still remained high. Traditionally the US and UK don’t have saving levels as high as Japan. Basically I’m asking if the US and UK economy would behave the same way as Japan’s?

Firstly, it depends on what happens to inflation.
  • If inflation is 10% and interest rates 11%. Real interest rates are 1%
  • If inflation is 0.5% and interest rates are 1.75%. Real interest rates are 1.25%
  • If we have deflation (falling prices) CPI of say - 2% and interest rates are 0%. Real interest rates are + 2%
Out of the three options savers would be better off in the situation of interest rates of 0%. If you try saying that to some savers they may not believe you. But, the impact of 0% interest rates does depend very much on inflation or deflation rate.

Then there is the issue of commercial bank rates. The bank of England may cut rates to 0%, but commercial banks may still offer savers some incentive to save because they need deposits. Where possible, commercial banks will resist the cut to 0% for saving and loans. I imagine that even with base rates of 0%, you could find somewhere to get say 2% on savings.

Who Benefits from 0% interest rates?

Borrowers will find mortgage payments cheaper, especially those on tracker / variable mortgages. Firms with loans will benefit from cheaper repayments. But, it is not all good news as 0% interest rates may occur because of falling asset prices. Homeowners are benefiting from low rates, but, suffering from falling equity. If UK house prices start to rise, I would imagine interest rates would increase again. Also if 0% interest rates occur with deflation. Real interest rates are quite high.

How is Exchange Rate affected by 0% interest rates?

If the UK has 0% interest rates and say Eurozone keep rates at 2%, there will be an outflow of money to Europe and the Pound will continue to depreciate. However, the eurozone economy is also in recession and Euro rates could follow UK rates.

When Japan had 0% interest rates and no one else did. It led to the Yen Carry trade where people borrowed in Japan and saved elsewhere. However, if the UK moves to 0% interest rates I imagine many others will have 0% rates as well.

Saving Rates in Japan.

Since the period of 0% interest rates, the measured Japanese Saving rate actually fell quite significantly. (I was a little surprised on researching this) This wasn't because people went out and spent; it reflected demographic changes and other changes in society. In this period consumer spending in Japan was generally stagnant because of deflationary expectations rather than 0% interest rates.


If interest rates were 0% and inflation stayed at the government's target of 2%, it would definitely be bad for savers and good for borrowers. However, I feel 0% interest rates will be introduced to stave off the threat of deflation. Therefore, the impact of 0% interest rates cannot be separated from deflation, or at least very low inflation.

If 0% interest rates do there job it will create inflation, then the 0% interest rates will be temporary. If they don't do there job and deflation sets in. We could experience a long period of 0% interest rates

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