Interest Rates

Interest Rates

The central bank is an important institution in a country because of the many functions that it performs. The central is responsible for controlling the monetary policy of a country. It has other responsibilities that are not limited to issuing national currency, maintaining the value of the currency, ensuring financial system stability, controlling credit supply, serving as a last-resort lender to other banks and acting as government’s banker. Depending on the country, the central bank might be independent or not. One of the major functions of the central bank is to maintain liquidity in the country, a function that entails the use of monetary policy and interest rates. Therefore, interest rates are an important factor in the execution of the functions of central bank. When the interest rates are not well managed by banks, interest rate risks may occur affecting all bank operations. This paper highlights the importance of managing interest rates in order to maintain stable long-term interest rates and avoid interest rate risks (Duffie & Singleton, 2003).

Ways in which Central Bank Controls Short-Term Interest Rates

The central bank has many functions as stated above. However, of importance to this study is the function of liquidity control through monetary policy and interest rates. The monetary policy is the policy of the central bank that enables the bank to manage the liquidity of the country. This involves issuance of currency, maintenance of foreign reserves and managing the cost of credit by regulating interest rate. The economic activity in a country is influenced by the monetary policy of the central bank.

Interest rates are one of the most important tools at the disposal of the central bank. The central bank uses short-term interest rates to implement its control of liquidity within a country. According to Roley & Sellon, (n.d, p. 5), short-term interest rates refer to the overnight interbank lending rate. Whenever the central bank wants to reduce the cost of credit, it lowers the short-term interest rates. The low short-term interest rates stimulate peoples’ activities as well as the activities of business and investors in the country. Many business, investors and people would take the advantage of the low interest rates to increase their borrowing and investments in the country, an act that will stimulate the economy through increased economic activities (Rahi & Zigrand, 2004). Contrary, increased interest rates discourage borrowing and therefore investment. Low investment will reduce business activities and economic activities in the economy thus reducing economic growth of a country.

Benefits of Short term Interest Rates

In a market economy, resources tend to flow to activities that maximize their returns for the risks borne by the lender. Interest rates serve as market signals of these rates of return. Although returns will differ across industries, the economy also has a natural rate of interest that depends on those factors that help to determine its long-run average rate of growth, such as the average investment rate of a nation. During low economic activity periods in an economy, monetary policy can push its interest rate target temporarily below the natural rate of the economy that lowers the real cost of borrowing. This is sometimes known as “leaning against the wind.”

To most economists, the primary benefit of low interest rates is its simulative effect on economic activity. By reducing interest rates, the Bank of England can help spur business spending on capital goods while also helping the long-term rates is improving bank balance sheets and the capacity of the bank to lend. During the financial crisis, many banks, particularly some of the largest banks, were found to be undercapitalized. This reduced their ability to make loans during the initial stages of the recovery. Low short-term interest rates can help the bank of England to recapitalize the banking system by helping to raise the industry’s net interest margin (NIM), which boosts its retained earnings and, thus, its capital (Kliesen, 2010).

Low short-term interest rates can raise asset prices. When the bank of England increases the money supply, the public finds itself with more money balances than it wants to hold. In response, people use these excess balances to increase their purchase of goods and services, as well as of assets like houses or corporate equities. Increased demand for these assets, else equal, raises their price. The lowering of interest rates to raise asset prices can be a double-edged sword. On the contrary, higher asset prices increase the wealth of households (which can boost spending) and lowers the cost of financing capital purchases for business. Moreover, low interest rates encourage excess borrowing and higher debt levels (Kliesen, 2010).

Disadvantages of Low Interest Rates

Despite the benefits of low interest rates to the economy and households, there are disadvantages too. Rajan (2010) argues that extended period of low interest rates can contribute to a boom and mark the increase in prices. Without a strong commitment to control inflation over the long run, the risk of higher inflation is one potential cost of the Bank of England’s keeping the real rate below the economy’s natural interest rate. Low interest rates provides a powerful incentive to spend rather than save. In the short-term, this may not matter much, but over a longer period, low interest rates penalize savers and those who rely heavily on interest income (Rajan, 2010, p. 9).

A second cost of very low interest rates flows from the first. In a world of very low real returns, individuals and investors begin to seek out higher yielding assets. Since the target rate for the bank is near zero, the securities of the treasury and the market rates have fallen. Despite these declines in rates, existing bondholders can realize significant capital appreciation. However, those desiring higher nominal rates might instead be tempted to seek out more speculative, higher-yielding investments. Kliesen (2010) notes that When economic resources finance more speculative activities, the risk of a financial crisis increases especially when excess amounts of leverage are used in the whole process.

Economists believe that banks and other financial institutions tend to take greater risks when rates are maintained at very low levels for a lengthy period. Low short-term interest rates relative to long-term interest rates can make banks and other financial institutions overinvest in long-term assets, such as Treasury securities. In situations where the interest rates rise unexpectedly, the value of those assets will fall, exposing banks to substantial losses. Additionally, low short-term interest rates reduce the profitability of money market funds, which are key providers of short-term credit for many large firms. Bullard (2010) argues that the ability of the bank of England to keep interest rates low for an “extended period” may lead to a Japanese-style deflationary economy. This is possible where there is a shock that pushes inflation down to extremely low levels.

Conclusion

Interest rates are very important to the bank of England in implementing the monetary policy. Low interest rates are used to stimulate economic activity in UK. They encourage borrowing and investment in the country while creating more employment and output. Thus, the low interest rates can be used to increase liquidity. Despite the benefits, low interest rates can discourage people from saving. Investors can only invest their savings. However, with low interest rates, there will be no incentive fro saving hence threatening the long-term state of investment. Therefore, as the Bank of England seeks to rejuvenate the economy, it should be aware of the negative effects of low interest rates.

References

Bullard, J 2010. Seven Faces of ‘The Peril.’ Federal Reserve Bank of St. Louis Review, Vol. 92, No. 5, pp. 339-52

Duffie, D & Singleton, K 2003, Credit Risk: Pricing, Measurement, and Management, (Princeton University Press).

Kliesen, K 2010. Low interest rates have Benefits … and Costs. Retrieved on November 14, 2010 from: http://research.stlouisfed.org/publications/regional/10/10/low_interest_rates.pdf

Rahi, R & Zigrand, J 2004, Strategic Financial Innovation in Segmented Markets, Working Paper, Centre for Economic Policy Research, No. 4176.

Rajan, R 2010, Bernanke Must End the Era of Ultra-low Rates. Financial Times, July 29, 2010. p. 9.

Roley, V & Sellon, G n.d, Monetary Policy actions and long-term interest rates, retrieved on June 23, 2010 from: http://12.35.11.68/publicat/econrev/pdf/4q95role.pdf