Many, most, maybe all central banks around the world lowered their interest rates to practically 0 (zero) in the last few months. I’ve been asked multiple times, by people who don’t follow global economy so closely, questions that made me think that it will be beneficial to some to have the answers in one place.
What is this interest rate that is being lowered all the time?
There are two interest rates controlled by the Federal Reserve Bank. One is called the “Discount Rate” – the rate in which banks borrow money directly from the Federal Reserve Bank in the US. The other one is the Federal Reserve Funds Rate – the rate in which banks borrow money from each other.
Why do central banks around the world lowering their rates?
The central banks are lowering the interest rates in an attempt to jump start the economy. The reasoning is relatively simple: when the price of money is cheap, and the rate paid on savings is low, people are encouraged to borrow and spend rather than save. Borrowing and spending create jobs, and boosts production.
Is it working?
The interest instrument is a good one, or at least it used to be in the past. The fact is that this time around it isn’t working.
Why isn’t it working?
Banks are too scared to loan money. The risk involved in loaning money, when calculated in the interest rate the banks charges people for loans is still very high. In other words, the banks are (or at least can) borrow money at very low rates (almost 0), but they are too scared to loan it away at low rates because the risk is too high. What’s happening is that the beneficiaries of the low rates are mainly, the banks, and not the citizens. Which is, by the way, contrary to the intention of the Federal Reserve Bank.
Is there a danger in the lower interest rates?
Of course. The Federal Reserve cannot lower the interest rate any more. Well, at least theoretically, it could have a negative interest rate in which banks will be paid to borrow… But then again, there’s no guarantee that the commercial banks will loan the money at low rates to the people and businesses that desperately need it…
Can the Federal Reserve do something about it?
Yes, at least three things I can think about. The Federal Reserve can and should fine banks that shy away from loaning money to the people. The Federal Reserve can and should provide the banks with guarantees to loans. Lastly, the Federal Reserve should set up a web site where people could apply for loans directly from the Federal Reserve. It isn’t very conservative, I know, but there’s nothing conservative about the current economy downturn…
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