"Euro-area banks can now borrow money from the European Central Bank (ECB
more cheaply than ever before. The ECB’s policy rate – also known as
the main refinancing rate – has stood at 0.5% since the beginning of May
this year. It was still above 4% in mid-2008 but has been lowered
progressively since then. At the moment, monetary policymakers have good
reason for setting the policy rate at that level. Yet their very
expansionary policy has also kept interest rates on the money and
capital markets low for a prolonged period now. This will chip away at
savings, steer banks towards riskier business and set the wrong
incentives for highly-indebted governments.
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 cheaper
By 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 savings
However, 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 enticing
Banks 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 money
Though 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
According to Bundesbank President Jens Weidmann, low interest rates
"tempt decisionmakers to delay reforms and necessary structural
"The stability of the financial system within European monetary union", speech held by Jens Weidmann in Munich on 11 July 2013."