With the corona virus outbreak, the global economy has come to a halt like never before. The global health emergency at the focal of the crisis, every sector has been affected with unemployment rates soaring and economies shrinking. A recession of this scale has made the policymakers worldwide to step up.
The central banks were the first to step in, but the question arises if their approach been effective? Just over a decade ago, the world was grappling with the global financial crisis. central banks, also known as the lenders of last resort, came into action. They took several measures to prevent the Great Recession from turning into a Depression. And one of the first steps was to lower the interest rates to rock-bottom levels. So why does any central bank cut rates during a crisis?
Impact of lowering interest rates
The interest rate is what central banks charge other lenders for short-term borrowing. This, in turn, affects how much interest consumers pay on their loans and earn on their savings. Low rates help people and businesses to take advantage of cheaper loans, which in turn, should boost the economy as they spend more on goods and services or invest in improving productivity. However, the real interest rates, which take inflation into account, are at historic lows since 2009 and have never rebounded despite a decade of economic expansion. There are a variety of factors which limit the ability of central banks to affect the real interest rates. These include low productivity levels, a surplus of global savings and economic growth prospects.
As the virus started spreading outside China, a series of central bank announcements followed. The US Federal Reserve was the first to surprise markets with an emergency cut in interest rates in early March, followed by a second cut later that month. With two separate announcements, the central bank brought its funds rate down to the range of 0 per cent to 0.25 per cent, a level first reached during the global financial crisis of 2008.
Following the Fed cut, central banks globally joined the rate cut spree, including major players such as The Bank of England, The Bank of Canada, The Reserve Bank of New Zealand and the Bank of Korea. As the global economy went into a tailspin, all these institutions agreed to cut rates as part of a coordinated effort to limit the damage caused by the corona virus outbreak.
Two sides
The question here is: “Can low rates help our economies sail through this crisis?” The corona virus-caused economic shock is one of a kind. Unlike the 2008 financial crisis, this a spillover from the real sector to the financial sector, and not the other way round. The virus is first and foremost a health issue, not something that emerged from financial institutions. Many economists, therefore, argue that cheaper loans won’t solve the crisis.
With around a third of the world’s population under lockdown, enabling people to spend more is not going to help much as they are all stuck at home. Besides restaurants, cinemas, and shops closed, consumers are left with far fewer ways to spend their money. Fears of a deepening recession have also dented investor confidence. There is a growing concern whether central banks have reached the limits of their arsenal. Over the past decade, these institutions have tested new and unconventional tools, including negative interest rates and cash handouts (also called Helicopter Money). Places like the Euro zone and Japan, central bankers have cut rates to levels even below zero. This means that financial institutions are getting paid to borrow cash and get penalised for keeping excess reserves.
Drastic measures
Has this system proven to be effective? The answer is a no . Japan has had negative rates since 2016, but the world’s third largest economy has been struggling with a stagnant economy and very low inflation for years. It’s a similar situation in the Euro zone, where the European central Bank lowered rates into negative territory in 2014, and there is still no clear timeline for recovery. Low, or even negative rates, have been a well-known solution to many problems in the economic landscape for the last decade.
With the ongoing health and financial crisis showing no signs of dying out, central banks are running out of tricks to mitigate the fallout. More broadly, there is a general consensus that no rate cut, or government funding will end the ongoing economic crisis, at least not until the core issue — the health crisis — is solved.
(The writer is currently pursuing PGDM in Banking and Finance from the National Institute of Bank Management, Pune. He worked with Endeavor Careers as a Content Associate in their publishing department for more than a year before deciding to pursue a career in management.)