Interest Rate: Money with a Discount Harms the Economy More Than Necessary

The European Central Bank, followed by Danmark’s Nationalbank, has started pushing interest rate down with primary goal to stimulate the economy growth in the euro zone and Denmark.  However, loose monetary policy in time of crisis can also have a negative effect: it stimulates over-pessimism, under-investment and high unemployment.

By Olena Denysyuk

On 2 May 2013, The European Central Bank has announces that “The interest rate on the main refinancing operations of the Eurosystem will be decreased by 0, 25 percentage points to 0.50%, starting from the operation to be settled on 8 May 2013.”  The next day, Denmarks Nationalbank has announced a reduction by 0, 10 percentage point and therefore reaching a new record low: in attempt to pull the euro economy out of the recession (seen from the graph).

 I fear a rather damaging – more than fixing- effect on the economy.

The transmission mechanism of monetary policy, as such, will not kick start the growth in the euro zone. How people react to it, might, or might not - economics and people’s behavior all go together. No need to remind how low interest rate during the 2000-2006 boom periods overheated not only the economy, but also the opportunism in people’s behavior. It was “rational” to lend money to low-income families, or families with poor history. It was “rational” to borrow money perceiving it was cheap. 

Thus, the combination of low interest rate and increasing housing prices created a belief that if a borrower was not able to pay a mortgage cost, a lender might liquidate a house and gain a return. Therefore, it was a “rational” reason not to cut interest rate and not to prevent the economy growing to quickly.

This is some of the logical reasoning how low interest rate in combination with other economic indicators can feed op over-optimism, over-consumption and over-investment, resulting in low unemployment.

Today we see the same story with the interest rate - but -, however, different outcomes: steady housing prices, high level of enforced sales, high unemployment rate, and negative growth rate in the euro zone. As The Economist of April 6^th wrote: 

“the message from the rich world’s central banks is clear: the era of ultra-loose monetary policy is here to stay.”

But where is a magic of the loose monetary policy, or how The Street commonly refers to it, of an “ease”? If central banks will be passively active on a bear market, will it do any better?

Partly, current well- being and future direction of the economy is predicted by people’s behavior. Therefore, it’s not the banks as such to reach a goal, but rather people’s perception of the banks’ actions.

So where is the risk in this extraordinary loose monetary policy for such a long period? 

Confidence

There are can be ghost effect of this monetary action: it might not work at all.  A prolonged low interest rate is more likely to drain confidence. It is very likely that market participants interpret it as a signal that the central bank has a more pessimistic assessment of the economy, than market participants. Therefore, this passive aggressiveness can do more harm, than good: the pessimistic economic interpretation and forecast will depress the economics even further.   

So, cutting interest rate to its lower rate ever, is not associated with measure of optimism. What the economy needs now is optimism!

Spending

According to economic reasoning, cheap money is essential for economic recovery.  The primary goal of low interest rate is to stimulate positively household spending and corporate investment decisions. Yes, especially now, with all these governmental cuts, tightening fiscal policy, austerity, the economy do need an “ease”. So we need cheap money to stimulate spending.

However, this extraordinary  low rates leave a limited leeway for a further reduction of Danmarks Nationalbank's lending rate. Thus, there are extremely limited room for mortgage and lending banks to push interest rate down for corporate and household lending.

The house- owners will NOT feel the effect of lower interest rate: less interest payments, meaning more for spending. But taking the pessimism on the market, they are more likely to save this extra money, anyways. Therefore, mortgage borrowers will not feel the effect of this low interest rate.

There is also a problem with the corporations- the economy needs new start- ups, new corporate investments and new projects. Worth mentioning, the majority of corporate activities include costs, other that capital cost.  Along with other corporate expenditures, the interest rate is just a small fraction from the cost pool. Therefore, the reduced interest rate is like a drop in the ocean for multinational corporations. Even more, this reduced interest rate will be traded off by higher bank charges, announced earlier this year.

So, there should be expected zero effect of low interest rate on households and corporations spending.

The Central Banks Goals Priority

The money should be used where the problem is, so should there be a policy focus. Well, it is not the central banks goal to decrease the unemployment (its goal is to sustain the inflation by about 2% level). Neither was the central banks focus to regulate the asset prices during the boom time - the seed of the current economic pessimism. Since the problem with the inflation rate is bitten (the changes in labour market – over –generous welfare benefits and growth in highly skilled professional- have positively benefited into it) the chances of high inflation or disinflation are low. I think, central bank might also include “unemployment problems” into their primary goal in recession times.

But my massage is clear: the unemployed won’t care about discounted money. The corporations won’t be stimulated by the lower interest rate only, at times of decreased demand. The central banks should also face other economic problems, as the whole economic mechanism can not be isolated.

Savings vs. Lending

As of this latest press release by ECB: “The interest rate on the deposit facility will remain unchanged at 0.00%”. For the Certificates of deposit in Danmarks Nationalbank there is a decline by 0.10 per cent.

If central banks will be passive with monetary policy for too long a period, the money lenders and borrowers will believe that their possible loss/ gain (which are set by banks to their customers) will be “killed” by the central banks, by uncertainty, in particular.

Here they are to kill the incentives for savings (which is important for national balance). Low interest rate on deposits for a long time might lead to withdrawals (if equity or bond market will promise higher returns, than any rational saver will jump into a deal that promise higher return).

This “extraordinary” event for a long time will also affect the risk tolerance of lenders. There might be two potential outcomes.  As a result of the underlying uncertainty of this passive aggressiveness (prolonged low interest rate), the lender will realise, that at some point, the central banks will raise the rate. The “extraordinary” long-time event of low interest rate might be seen as coming train: it is still far, but reaches you at a speed, that you are less expecting. Taking this uncertainty, generated by this “extraordinary event”, the lender will, therefore, become less risk takers. It can because new problems in behavioural finance- pessimism, under-pricing of stock.

From another side, low interest rate might stimulate the “animal spirits” and the financial manias as an outcome, as seen during 2003-2006 boom periods. As many investors today are hungry after return on investments, this “extraordinary” period of low interest rate may again lead to a new property boom, or any other asset bubble. Those two potential outcomes will be hurting for the economy.

Conclusion

Any economic mechanism is not operating in a vacuum. Therefore, any change in economic activity will change the behaviour of market participants as well.

So, can low interest rate policies be relevant when facing another economic problem: high unemployment rate? How will this money with the discount help unemployed?

Often, I have a strong intuition about economy (at the same time I acknowledge the fact, that you should never trust your gut feeling). This time, my intuition – based on my knowledge of behavioural finance - says, as long as there will be cheap money in combination with high unemployment, there will not be economy growth. Our behavioural psychology cannot understand this odd combination: the combination of low interest rate and high unemployment. Our well-being needs stability on the job market first, and not to be fed by cheap money.

Economy needs “optimism” measures, and not only the symptom treatment – that is providing ineffective cheap money. Without the stimulation of optimism measures in the economy, the euro zone will stay in the black-out period forever.

The chart below provides a schematic illustration of the main transmission channels of monetary policy decisions.(Source: http://www.ecb.europa.eu)