For central banks like the ECB, policy rates are the most important tool for keeping the value of their currency stable, in line with their mandate. The policy rate determines how much commercial banks must pay to borrow money from the central bank. A central bank also uses its policy rate to influence conditions on the "money market"; via various channels, this then affects demand in the economy as a whole and, ultimately, the price level.
Interest rate cuts make central bank money cheaperBy deciding to lower its policy rates, for example, a central bank initiates the following process. The lower policy rates make it cheaper for commercial banks to borrow central bank money. This enables the commercial banks to offer cheaper loans to enterprises or consumers, who are then more inclined to make investments and buy goods and services because of the favourable lending conditions. If investment and consumption increase overall, the aggregate demand in an economy rises and the economy gathers momentum.
So it is easy to see why the ECB has lowered its policy rate time and again in recent years: this is one of the many measures it has taken to alleviate the effects of the financial and sovereign debt crisis and stabilise economic developments in the euro-area countries. Given the limited risk of inflation, the ECB has been able to do this without jeopardising its objective of maintaining price stability over the medium term.
Inflation chips away at savingsHowever, a sustained period of low interest rates poses the risk of a rise in prices after a certain length of time. If consumer prices increase across the board rather than just for some specific goods and services, a currency loses some of its value in a process called "inflation". Yet this does not merely affect day-to-day purchases. A lengthy period of low interest rates can also encourage investors to channel large amounts of money into assets such as real estate, stocks or precious metals, causing their prices to rise. This risks generating dangerous speculative bubbles. The central bank then has to raise its policy rate early enough to avoid losses in purchasing power and the emergence of price bubbles.
According to Bundesbank President Jens Weidmann, there should be "a timely rise in key interest rates if there are signs of increasing price pressures in the future".
Otherwise, savers in particular will suffer the ill-effects of low interest rates. Call deposit accounts or fixed-term savings accounts yield little profit if their interest rates are low. If interest rates on savings accounts are below the rate of inflation, savers will make a loss on their deposits: the real value of their savings will fall, making it less and less attractive to put money aside for the future.
Risky investments become enticingBanks and insurance companies face similar problems to savers. They have to make profits in the long term even when interest rates are generally very low. They tie up some of their customers’ money in long-term investments, such as ten-year Bunds (bonds issued by Germany’s central government), which are viewed as particularly safe. Once these securities mature (ie become due for repayment), banks and insurers have to reinvest these funds subject to new terms and conditions. In the present market environment, however, the return on these kinds of investment is so low that they only generate a small profit for banks and insurance companies.
Financial institutions therefore often look for more profitable investments. They move their funds from low-interest, comparatively safe investments to higher-yielding, riskier ones. This, in turn, can generate risks to the stability of the financial system.
Recent figures on developments in financial assets in Germany reflect a search for higher potential returns: in the period under review, households withdrew funds from fixed-term and savings deposits and from fixed-interest securities, channelling more money into stocks and mutual fund shares. Businesses also invested heavily in securities and reduced their bank deposits.
Yet all of this is apparently still being overshadowed by another effect: the ongoing crisis has shaken confidence in many quarters. If in doubt, investors are tending to go for comparatively safe options, in what economists dub a "flight to safety". Future developments in asset prices and risk-taking still warrant careful observation, however.
The temptations of cheap moneyThough a headache for investors, the low interest rates are a blessing for anyone taking out new loans: they have made borrowing extremely cheap, above all for governments. A sustained period of low interest rates is therefore very much in a government’s interests, all the more so if its existing debt is high: higher interest rates would increase the financial burden on indebted governments.
Reforms and structural change are needed in order to overcome the sovereign debt crisis. However, the low interest rates are easing the pressure on governments to actually tread the thorny path of change. They might be tempted to pressurise central banks into maintaining low policy rates for as long as possible to avoid any major changes to these attractive conditions.
According to Bundesbank President Jens Weidmann, low interest rates "tempt decisionmakers to delay reforms and necessary structural changes".
1. "The stability of the financial system within European monetary union", speech held by Jens Weidmann in Munich on 11 July 2013."