Interest rate targets are a vital tool of
monetary policy and are taken into account when dealing with variables like
investment,
inflation, and
unemployment. The
central banks of countries generally tend to reduce interest rates when they wish to increase investment and consumption in the country's
economy. However, a low interest rate as a macro-economic policy can be
risky and may lead to the creation of an
economic bubble, in which large amounts of investments are poured into the real-estate market and stock market. In
developed economies, interest-rate adjustments are thus made to keep inflation within a target range for the health of
economic activities or cap the interest rate concurrently with
economic growth to safeguard economic momentum.
History In the past two centuries, interest rates have been variously set either by national governments or central banks. For example, the Federal Reserve
federal funds rate in the United States has varied between about 0.25% and 19% from 1954 to 2008, while the
Bank of England base rate varied between 0.5% and 15% from 1989 to 2009, and Germany experienced rates close to 90% in the 1920s down to about 2% in the 2000s. During an attempt to tackle spiraling
hyperinflation in 2007, the Central Bank of
Zimbabwe increased interest rates for borrowing to 800%. The
interest rates on prime credits in the late 1970s and early 1980s were far higher than had been recorded – higher than previous US peaks since 1800, than British peaks since 1700, or than Dutch peaks since 1600; "since modern capital markets came into existence, there have never been such high long-term rates" as in this period. Before modern capital markets, there have been accounts that savings deposits could achieve an annual return of at least 25% and up to as high as 50%.
Influencing factors •
Political short-term gain: Lowering interest rates can give the economy a short-run boost. Under normal conditions, most economists think a cut in interest rates will only give a short term gain in economic activity that will soon be offset by inflation. The quick boost can influence elections. Most economists advocate independent central banks to limit the influence of politics on interest rates. •
Deferred consumption: When
money is loaned the
lender delays spending the money on
consumption goods. Since according to
time preference theory people prefer goods now to goods later, in a free market there will be a positive interest rate. •
Inflationary expectations: Most economies generally exhibit
inflation, meaning a given amount of money buys fewer goods in the future than it will now. The borrower needs to compensate the lender for this. •
Alternative investments: The lender has a choice between using his money in different investments. If he chooses one, he forgoes the returns from all the others. Different investments effectively compete for funds. •
Risks of investment: There is always a risk that the borrower will go
bankrupt, abscond, die, or otherwise
default on the loan. This means that a lender generally charges a
risk premium to ensure that, across his investments, he is compensated for those that fail. •
Liquidity preference: People prefer to have their resources available in a form that can immediately be exchanged, rather than a form that takes time to realize. •
Taxes: Because some of the gains from interest may be subject to
taxes, the lender may insist on a higher rate to make up for this loss. •
Banks:
Banks can tend to change the interest rate to either slow down or speed up economy growth. This involves either raising interest rates to slow the economy down, or lowering interest rates to promote economic growth. •
Economy: Interest rates can fluctuate according to the status of the economy. It will generally be found that if the economy is strong then the interest rates will be high, if the economy is weak the interest rates will be low.
Zero rate policy A so-called "zero interest-rate policy" (ZIRP) is a very low—near-zero—central bank target interest rate. At this
zero lower bound the central bank faces difficulties with conventional monetary policy, because it is generally believed that market interest rates cannot realistically be pushed down into negative territory. In the United States, the policy was used in 2008-2015, following the
2008 financial crisis, and 2020-2022, during the
COVID-19 pandemic.
Negative nominal or real rates Nominal interest rates are normally positive, but not always. In contrast, real interest rates can be negative, when nominal interest rates are below inflation. When this is done via government policy (for example, via reserve requirements), this is known as
financial repression, which was practiced by countries such as the United States and United Kingdom
following World War II until the late 1970s or early 1980s, during and following the
Post–World War II economic expansion. In the late 1970s,
United States Treasury securities with negative real interest rates were deemed
certificates of confiscation. A so-called "negative interest rate policy" (NIRP) is a negative central bank target interest rate.
Theory In theory, profit-seeking lenders will not lend below 0% if given the alternative of holding cash, as that will guarantee a loss. Likewise, a bank offering a negative deposit rate will find few takers, as savers will instead hold cash. Negative interest rates have been proposed in the past, notably in the late 19th century by
Silvio Gesell. A negative interest rate can be described as a "tax on holding money"; Gesell proposed it as the
Freigeld (free money) component of his (free economy) system. To prevent people from holding cash, Gesell suggested issuing money for a limited duration, after which it must be exchanged for new bills; attempts to hold money thus result in it expiring and becoming worthless. Along similar lines,
John Maynard Keynes approvingly cited the idea of a carrying tax on money, but dismissed it due to administrative difficulties. In 1999, a carry tax on currency was proposed by
Federal Reserve employee Marvin Goodfriend, to be implemented via magnetic strips on bills, deducting the carry tax upon deposit, the tax being based on how long the bill had been held.
Practice Both the
European Central Bank starting in 2014 and the
Bank of Japan starting in early 2016 pursued the policy on top of their earlier and continuing
quantitative easing policies. The latter's policy was said at its inception to be trying to "change Japan's 'deflationary mindset.'" In 2016
Sweden, Denmark and Switzerland—not directly participants in the
Euro currency zone—also had NIRPs in place. Countries such as Sweden and Denmark have set negative interest on reserves—that is to say, they have charged interest on reserves. In July 2009, Sweden's central bank, the
Riksbank, set its policy repo rate, the interest rate on its one-week deposit facility, at 0.25%, at the same time as setting its overnight deposit rate at −0.25%. The existence of the negative overnight deposit rate was a technical consequence of the fact that overnight deposit rates are generally set at 0.5% below or 0.75% below the policy rate. The Riksbank studied the impact of these changes and stated in a commentary report that they led to no disruptions in Swedish financial markets.
Government bond yields in 2011, And rates went negative after the
European debt crisis. During the
European debt crisis, government bonds of some countries (Switzerland, Denmark, Germany, Finland, the Netherlands and Austria) have been sold at negative yields. Suggested explanations include desire for safety and protection against the eurozone breaking up (in which case some eurozone countries might redenominate their debt into a stronger currency). ==Macroeconomics==