Central banks, by lowering interest rates, can keep stock markets from collapsing and greatly alleviate the crisis in the real economy. The price, however, is the dependence of companies and consumers on cheap credit, as well as the risk of high inflation. And if interest rates stay low for too long, raising them again becomes virtually impossible.
Determination of interest rates
The interest rate is, in the broadest sense, the price to be paid for the capital provided to us. Most often it is expressed as a percentage on an annual basis. The most important thing interest rates and the stock market in economics include: official central bank rates and market rates. The first informs at what cost commercial banks can conduct various types of operations with the central bank. In turn, the level of the latter is set in the so-called interbank market. Market rates have a direct impact, including on the cost of loans and borrowings taken by businesses and individuals.
Usually, official interest rates are set monthly at meetings of the Monetary Policy Committee. In total, the MPC determines the level of five types of rates: reference, pawnshop, deposit, radiant and discount.
Interest rates and inflation
Inflation is one of the most important parameters taken into account when determining the level of official interest rates. If inflation is high and exceeds the so-called inflation target (the level of inflation that is considered optimal), the central bank may decide to raise the rate. This will lead to an increase in interest rates, including on deposits and bonds, and a simultaneous increase in borrowing costs. This, in turn, should result in more people, instead of spending money, wanting to save it. Thus, the mass of money in circulation should decrease, which will lead to lower inflation (or negative inflation).
Conversely, if inflation is too low. If it stays below target for too long, the central bank could cut interest rates. As a result, loan rates will be lower, which should be an incentive to obtain and use them. At the same time, it will be less profitable to keep money, for example, on a bank deposit (they will have lower interest rates), which can be an incentive to withdraw money from the bank. Thus, more money could potentially enter the market, thereby increasing aggregate demand and ultimately increasing inflation.
Side effects of lower interest rates
While central bank stimulus policies support financial markets and the real economy, it also has many side effects. The first is the dependence of businesses and consumers on cheap money. When someone takes out a mortgage today they will pay only 2.5% interest. But if in the future interest rates rise even slightly, the size of their installments will increase sharply. It is enough to raise interest rates by only 1.5 percent to increase its value by almost 30 percent with a 30-year loan. Given the difficult budgetary situation of many individuals (and some companies as well) such an increase could lead to financial disaster. Therefore, it is common to say that lower interest rates are a one-way street. They are easy to omit.
Former chairman of the US Federal Reserve Jerome Powell was convinced of this. His strategy of raising interest rates in late 2018 had to change. A few symbolic increases were enough (for 2018, the effective interest rate of the Fed increased by 1 basis point) to bring the US economy to the brink of recession. With an effective interest rate of only 2.4% (December 2018), the economy began to show signs of destabilization and risk recession rose sharply. For comparison, back in the 1990s, the US market functioned well with interest rates of 5-6%. The second side effect is the risk of high inflation. At low interest rates there is no incentive to save. For this reason, many consumers instead of saving on a rainy day, prefer to spend their savings on current needs while supporting themselves with cheap loans. However, their increased demand leads to rising prices, which further accelerates the spiral of inflation. Other consumers are hearing about all the faster ri
sing prices, will be even more willing to spend a lot, because postponing them is completely unacceptable (because inflation means lower savings).
Understand the benefits of falling interest rates
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