The interesting thing about interest rates


  • Author: Grant Murgatroyd
  • Date: 07 Nov 2017
  • Copyright: Image appears courtesy of Getty Images

We try to protect our economic well being with monetary policy. The tools make perfect theoretical sense, but do they actually make a difference in practice? Grant Murgatroyd looks at some statistical evidence.

We’re all familiar with cycles of “boom and bust”. The economy motors ahead, crashes, recovers, builds up steam and crashes again. Central bankers, appointed by governments, are responsible for managing economies and deciding monetary policy. The US Federal Reserve was granted independence by Congress in 1913, Britain’s Bank of England in 1997 and the European Central Bank has been independent since the creation of the euro in 1997, a model based on Germany’s Bundesbank.

It’s important stuff and affects every one of us. Central banks have three main tools: open market operations (buying and selling securities), reserve requirements (the amount of money banks must hold) and discount rates (the interest rate at which banks can borrow). They guide economies using one or more of these tools to affect the amount of money that is in the financial system, known as “liquidity”.

The most obvious is interest rates, which is why every comment on interest rates by a central banker is front-page news. Alan Greenspan, who was chairman of the Federal Reserve from 1987 to 2006, was famous for making hints as to where interest rates might go, with markets responding such that drastic actions were not required. Greenspan once said to Congress: “I should warn you, if I turn out to be particularly clear, you've probably misunderstood what I've said.”

thumbnail image: The interesting thing about interest rates

Rational actors

The theory is straightforward. When interest rates are low, people and businesses will be inclined to borrow more to spend and invest, while they will save less because the returns from investments are lower. These changes in behaviour will stimulate economic growth. If an economy is overheating and headed for a crash, raising rates will curb borrowing and slow it down.

The other tools of central bankers are designed to have the same effect. For example, buying securities when demand is low will boost the price, whilst lowering reserve rates would stimulate lending by allowing banks to lend more. “The net effect of lower interest rates through this cash-flow channel is to encourage higher spending in aggregate. The opposite occurs when interest rates are increased,” the Bank of England says in ‘How does monetary policy work?’ (1)

Irrational numbers?

Does monetary policy work? The graphs at the end of this article imply that it doesn’t. Taking the UK as an example (it’s a more homogenous market than the US and data is more easily comparable), we can look at the relationship between interest rates and mortgage lending over the past two decades.

Numbers don't tell lies?

Bank of England Base Rates: 1997-2017

UK Mortgage Approvals: 1997-2017

From 1998 through 2008, Bank of England base rates moved downwards, from a peak of 7.5% in the summer of 1998 (shortly before a bond default by Russia) to 3.5% in late 2003, rising back to 5.75% in 2007. Three 0.25% rate reductions in 2007 and 2008 were designed to slow a booming market but their impact was minimal. In October 2008 investment bank Lehman Brothers collapsed and interest rates went from 5% to 0.5% in six months. UK base rates stayed at 0.5% until June 2013 when the British electorate voted to leave the European Union and the Bank of England cut rates to 0.25%.

From 1998 through 2003, while the Bank of England was reducing rates, mortgage approvals increased from 50,000 to more than 90,000. Rate increases through 2004 saw a fall in approvals to below 50,000, though they soon picked up. The period from 2005 through 2007 saw rates and mortgage approvals rising simultaneously. The Global Financial Crisis was first felt in 2007 and ran through 2009, though its legacy is still with us. Interest rates fell below inflation (negative real interest rates) yet mortgage approvals slumped below 20,000 and have trended at 30-40,000 ever since, a third of the peak rate. It is worth noting that over this period the Bank of England injected $435bn into the bank system through its Quantitative Easing (QE) programme (sometimes referred to as “printing money”).

After a crisis we tell ourselves we understand why it happened and maintain the illusion that the world is understandable. In fact, we should accept the world is incomprehensible much of the time.”
- Daniel Kahneman, winner of the Nobel Prize for Economics, 2002

The land of the negative interest rate

In Japan, the key short-term interest rate is currently -0.1%. Interest rates were drastically reduced in the early 1990s, dropping from over 3% to 0.5% and they have remained extremely low ever since. Real interest rates (the interest rate after inflation has been taken into account) have been negative for most of the past 25 years.

What impact has this had on borrowing? Overall, private sector lending volumes have fallen from more than ¥500trn in 1990 to less than ¥400trn for most of the past 20 years. Interest rose from 0% to 0.5% in 2008 and there was a subsequent fall in borrowing, but this coincided with the Global Financial Crisis.

Free money?

Japan Interest Rates 1997-2017

Japan Loans to Private Sector 1992-2017

Incomprehensible beings

There appears to be little recent research into the relationship between interest rates and lending, with economists focusing on impact on other areas, such as economic growth, stock markets and exchange rates. A 2001 working paper for the European Central Bank, concludes that demand for loans does increase “the coefficients of real short-term interest rates and long-term interest rates show negative signs, which suggests that the model employed is describing a demand phenomenon”.

It is too simplistic to say that interest rates do not work as a mechanism of encouraging or discouraging lending. There is no data on what would have happened if rates had not been cut and money not pumped into the system. Other factors, such as consumer and business confidence, and changes in the credit markets, are at work. “The financial crisis gave rise to an unprecedented market fragmentation, which impaired the smooth functioning of the monetary policy transmission mechanism,” Jean-Marc Israel of the European Central Bank said in a 2017 paper (2).

Monetary policy tools are based on an assumption that human beings are economically rationally. In 2002, Israeli-American psychologist Daniel Kahneman was awarded the Nobel Prize for Economics for his work in behavioural economics. He believes that it is not so much that we fail to learn from crises, more that it is impossible to predict human behaviour. He says: “After a crisis we tell ourselves we understand why it happened and maintain the illusion that the world is understandable. In fact, we should accept the world is incomprehensible much of the time.”



(2) Recent ECB experience of rapidly evolving monetary policy and its statistical implications, IFC Bulletins, Bank for International Settlements, 2017.

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