Wednesday, July 28, 2010

Limitations of Zero Interest Rates

In recent weeks, I have frequently been repeating the mantra if you tighten fiscal policy, you need loose monetary policy. i.e. If the government raises taxes and cut spending, we need low interest rates to maintain growth of aggregate demand and economic growth. (e.g. Interest rates forecast to remain at zero)

It sounds nice and simple, and suggests we can undertake any amount of fiscal tightenening so long as monetary policy can be sufficiently loose.

You could think of a see saw, if you put more weight on one side (fiscal policy on one side, you need more monetary policy on the other side).

However, there are limitations of zero interest rates.

Liquidity Trap.

A liquidity trap is a situation where zero interest rates fail to increase the demand for money. This may be because of:
  • Banks unable / unwilling to lend.
  • Consumers lacking in confidence to borrow, despite cheap borrowing, they prefer to pay off debt.
  • Commercial banks not passing on base rate cuts to consumers. (It's funny that I'm always writing about zero interest rates, but, the cut in base rates hardly affected me. My mortgage lender Standard Life, just simply failed to pass rates cuts onto my mortgages. I'm actually paying more now, than I did two years ago)


This is more of a problem for US and EURO, who are closer to the prospect of deflation. Basically deflation or very low inflation means real interest rates can be high, despite low nominal rates.
e.g. if prices are falling 2%, zero interest rates still make it attractive to horde cash and not spend. Japan discovered that a period of deflation makes zero interest rates meaningless for increasing growth.

Distortion Effects of Zero Interest Rates

Zero interest rates also have distortionary effects on rest of economy
  • Redistribution of income from savers to borrowers (at least with positive inflation like in UK, in a situation of deflation, this is not the case.
  • Can lead to misallocation of funds to speculative investment and asset bubbles. More on zero interest rates and asset bubbles
  • There is a concern that firms may load up on short term debt because it is cheaper to finance than long term.
  • People get used to zero interest rates, then when they rise, they can't afford the higher borrowing costs.
It all depends on the state of the economy. In a liquidity trap with prospect of double dip recession, the problems of zero interest rates are much greater than the distortionary impact of low interest rates. For all the months of zero interest rates, I don't see any looming asset bubble or reckless borrowing. In fact it is the opposite with low confidence outweighing the seeming attraction of zero interest rates.

But, the limitations of zero interest rates also shows the need for either more unorthodox monetary policy (quantitative easing) or a need to be cautious with fiscal policy, and only tighten when there is sufficient strength in economy.


No comments: