Why Can’t The Reserve Bank Lower Interest Rates Below 0%?

06 Sep

The reserve bank uses interest rates to keep the economy growing, but not too fast. Without them, we’d go through uncontrolled waves of unemployment (when things slowed down) and inflation (when things sped up). Interest rates are not a perfect tool for this, but they are what we have.

Banks borrow from the reserve bank at the interest rate the reserve bank sets. The banks borrow money in order to lend it out at a profit. If the economy gets too hot, the Reserve Bank raises interest rates, so people are less keen to borrow and spend/invest, and the economy cools down. If the economy slows down too much, the Reserve Bank lowers rates to make it cheaper for people to borrow and spend/invest.

All this assumes there are people who want to borrow to spend/invest – and, in either case, the fed isn’t directly lending to people who spend, it lends to lenders. The lenders choose whether or not to lend, but if it’s costing them money to hold the cash, they’ll lend as much as they can.

Now, suppose people are so unwilling to borrow to spend/invest that you have to offer 0% interest rates, or even negative rates to persuade them. This is the situation faced by most of the developed world right now.

If the Reserve Bank made the interest rate negative, effectively paying lenders to take money, the banks would happily slurp up the cash. Unfortunately, there’d be no incentive for them push the money out to the (non-)spending public. After all, why should a bank pay you 1% per year to borrow $500000 for a house, when they can just keep the $500000 in their vault for free? Cash in the vault pays 0% interest no matter what the state of the economy.

So, when demand is so low that nobody is willing to borrow to spend/invest, even at negative interest rates, the fed can try to make interest rates negative, but no matter how low they push them (-3%? -10%? -50%?) the banks will just hold the cash (thank you very much, Mr Bernanke!) and there’ll still be no boost to the economy.

That’s why the standard prescription for escaping recessions (letting the Reserve Bank adjust interest rates) is failing. The interest rates are as low as they can go already.

Reserve Bank manifestos should come with a warning on the packet – “if pain persists, consult your family macroeconomist”


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