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23 February 2024

Zero rates, zero growth, zero inflation

By Pradeep Unni

Zero rates! That sounds like a lot of cheap money. But wait, firstly can interest rate reach zero if global economies fail to recover? And if it really happens, does that really mean free money for consumers or businesses? What next from US after it slashed it rates between zero and 25 per cent? Can there be a deflation in global economies despite the bailout and liquidity additions? And finally can there be a global recession or will it get restricted to key economies? Similar such questions have been bombarded to me from many and I have been pondering on this for quite a while and these are few of my thoughts.

Firstly, I learn that even if central bank rates did drop to zero, it would not mean free money for consumers or businesses. The zero rates would only apply to the reserves that banks are required to maintain and that they lend to one another. Customers would still have to pay some interest, but the rates could be extremely low for some business borrowers. However, savings remaining idle in banks might earn lower interest and this is specifically done to prompt fresh investments rather than parking their money in banks.

The zero interest-rate policy (ZIRP), as economist term this, has been slowly crawling into key economies and might become more evident in other nations as inflation eases in these benchmark economies (UK, US and EU). Once ZIRP becomes evident central banks would be fighting deflation (as the case is in Japan) than hyper inflation that has been prevalent a year before.

Japan still struggles with deflationary economy and the current crisis has worsened its status. In its last move, the Bank of Japan slashed its policy rate from 0.30 per cent to 0.10 per cent, a twenty basis point cut. Economists, however, foresee a bleak chance for fresh borrowing getting triggered due to this 20 basis point cut, which has been largely priced in. In fact, ZIRP never actually worked for the Japanese economy as the nation continues to be in prolonged economic deterioration despite dropping overnight rate to zero for the first time in 19 March 2001. With this history in hand, many doubt the efficiency of ZIRP in the US and other nations.

Despite this, the US seems to be comfortable (until now) in maintaining low rates though former Treasury Secretary Ben Bernanke has himself stated in one of his key research papers (in 2004) that "the success over the years in reducing inflation and, consequently, the average level of nominal interest rates has increased the likelihood that the nominal policy interest rate may become constrained by the zero lower bound on interest rates. When that happens, a central bank can no longer stimulate aggregate demand by further interest-rate reductions and must rely instead on 'non-standard' policy alternatives".

Against a background of weak consumer demand and rising unemployment in key nations, a deflationary economy might emerge. This might make recovery in economy even harder as deflation deters credit growth (as debts become progressively more expensive in real terms) and consumption (as consumers might consider that goods will be cheaper in the future).

Technically, the Federal Reserve has "ample scope" to aid an extremely weak US economy and could hold interest rates near zero for the rest of 2009 or longer if needed as it can print any amount of US dollar if the need arises. Bernanke had justified such policies on the grounds that "the prevention of deflation remains preferable to having to cure it. If we do fall into deflation, [i.e. lower housing prices] we can take comfort that the printing press can assert itself, and sufficient injections of money will ultimately always reverse a deflation".

In his remarks, Bernanke has stated that the simplest and more preferable method to avoid deflation and maintain lower rates would be for the Fed to begin announcing explicit ceilings for yields on longer-maturity Treasury debt (say, bonds maturing within the next two years). The Fed could enforce these interest-rate ceilings by committing to make unlimited purchases of securities up to two years from maturity at prices consistent with the targeted yields. This could bring the yields on medium-term Treasury securities and also yields on longer-term public and private debt (such as mortgages) to fall. Lower rates over the maturity spectrum of public and private securities could strengthen aggregate demand in the usual ways and thus help to end deflation.

Quantitative easing (QE) is yet another way of boosting economic growth after traditional monetary policy tools such as interest rate targets have been exhausted. In QE, central banks flood the banking system with masses of money, more than that is needed to keep official interest rates at zero or at a low rate, to shore up financial systems and promote lending. They usually do this by buying up large quantities of assets from banks. In simple terms, we can regard this as central banks' printing more money. Such non-traditional policy measures were first used by Japan way back in March, 2001 ( it ended in 2006). During this time-frame, the Bank of Japan instead of cutting short-term rates, set a target for the amount of money it force-fed into the banking system. The funds were injected mainly through the BoJ's purchases of government and commercial securities from banks.

But a gentle remainder – weren't low interest rates for a longer time-frame in major economies the root of cause of current problems (sub-prime crisis)?

Are we doomed to repeat – after a couple of years from now – complex structured products developed to hunt for higher returns? Leverage is twin-edged sword and if not used with greater diligence it might strike back with greater vengeance. Having been bailed out this time, a false notion of rewarding failure using the taxpayer's money should be taken for granted.

The current crisis has most often been compared to the great global depression of 1930s and many remark this is more severe than earlier one. With fresh news of sustained troubles in banking sectors (RBS, Barclays) emerging every other day, fears of this crisis turning into a major global economic gloom cannot be ruled out. But the major difference between the Great Depression and the current chaos is the extent of global participation and initiatives that has been taken to curtail the crisis.

Liquidity injection, bailouts, outright buyouts and co-ordinated interest rate cuts have certainly reduced the impact of a crash landing. But the extend of damage and the time required to recover is not clear yet. Governors of central banks certainly have greater number of policy tools now to prevent economic problems from getting as bad as the Great Depression of the 1930s and due to this a global recession might be averted.

As the policies introduced tend to bear fruit, gloomy days might disappear slowly and remember it is always the darkest before dawn.

The writer is a Senior Research Analyst at Richcomm Global Services DMCC