Since the financial crisis in 2008, the term “low interest rate policy” has become a constant companion for media users. The responsible central bank is responsible for the interest rate policy of an economy. Within the European Union, this task no longer falls to the national central banks, as in the USA, for example, but to the European Central Bank (ECB). Why do central banks pursue a low interest rate policy, what are their goals?
- A low interest rate policy is the most important tool for stimulating growth in the economy.
- After the financial crisis in 2008, the low interest rate policy in Europe culminated in negative interest rates.
- The risk of the low interest rate policy lies in the over-indebtedness of private households.
- High interest rate policy as a counterpart serves to fight inflation.
Central banks in the economic field of tension
The classic tasks of a central bank include four positions:
- Securing price stability
- Solid job market
- Maintaining the balance in foreign trade
- Steady economic growth
The problem of this area of tension, not called “magic square” for nothing, is obvious. Steady economic growth often leads to a foreign trade surplus. Full employment with high income standards fuels inflation. The art of central bankers lies in getting as close as possible to the balance between the four cornerstones. Interest rate policy plays a decisive factor in this. According to abbreviationfinder, ZIRP stands for Zero-Interest Rate Policy.
The economy can be controlled via interest rates
The interest rates are the most important instrument to stimulate economic growth or inflation counteract. Since the financial crisis, not only in Europe, some economies have been in trouble. Banks went into a tailspin, lending to the manufacturing industry was only operated restrictively.
The result was that companies could no longer invest and employees were laid off. Consumption fell due to the rise in unemployment. Declining consumption, in turn, had a negative impact on companies. In the end, this downward spiral forms a vicious circle.
The central banks then resorted to the low interest rate policy. By lowering interest rates to an all-time low, including negative interest rates for commercial bank balances at the ECB , it was intended, on the one hand, to stimulate credit demand from the private sector.
An increase in lending leads to more investment, to a revitalization of the labor market, resulting in an increased demand for goods by private households. Ideally, a low interest rate policy is the exact opposite of the consequences of restrictive lending.
How can interest rates be lowered? The central banks have two options for initiating interest rate cuts in the market. On the one hand, they can lower the deposit rate that banks receive for short-term deposits at the central bank. This makes it uninteresting for the commercial banks to park money with the central banks. Second, there is the possibility of setting the refinancing interest rate for commercial banks extremely low. This also reduces the interest rate that companies and households have to pay on loans.
How can interest rates be lowered?
The central banks have two options for initiating interest rate cuts in the market. On the one hand, they can lower the deposit rate that banks receive for short-term deposits at the central bank. This makes it uninteresting for the commercial banks to park money with the central banks. Second, there is the possibility of setting the refinancing interest rate for commercial banks extremely low. This also reduces the interest rate that companies and households have to pay on loans.
Bond purchases as a last resort
The third way is to flush massive amounts of money into the market. The European Central Bank is not allowed to provide direct financing to individual states. Against this background, it has been practicing the controversial variant of bond purchases for several years.
Private banks buy government bonds from issuing countries. The ECB, in turn, buys the government bonds from the banks. This means that the banks receive billions of euros, which in turn are to be brought onto the market as low-interest loans. The billions that the ECB has paid to park there as a deposit is of no interest due to marginal or negative interest rates.
Consequences of the low interest rate policy
Conservative savers and investors in particular are feeling the effects enormously. Hardly any interest is paid on savings deposits. Investors transfer their money to other countries where they can expect higher returns on their savings.
In a few years the Federal Republic of Germany made money by borrowing money. In times of crisis, the demand for government bonds from Germany was so great that they were issued with a premium that exceeded the interest rate to be paid.
If overnight money and time deposits are uninteresting, the demand for real estate as a conservative investment inevitably increases. This demand is given an additional boost by the very low interest rates for mortgage loans. A tight real estate market can also be pushed into a bubble by a policy of low interest rates.
On the other hand, above-average low interest rates for consumer loans actually motivate consumers to rely more on consumer goods financing and thus to provide impetus for the economy.
The US example from 2017 to 2020 shows, however, that such an economic stimulus can also be deceptive. The positive trend is declining and the economy is stalling. The result is an increase in unemployment. Real estate and houses financed on credit or heavily used credit cards can lead to another banking crisis – the game starts all over again.
When will a high interest rate policy take effect in return?
A booming economy with full employment goes hand in hand with an above-average demand for goods. The high demand in turn leads to above-average price increases. The aim of the ECB is an inflation rate in the euro zone of just under two percent. If inflation rises, higher interest rates lead to a decline in demand in both the commercial and private sectors. Falling demand in turn means that companies have to lower prices in order to be able to continue selling. The high interest rate policy acts as a brake when too much money in the market drives up prices.