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07/12/2008 | Rate Cuts Nearing the Bottom

Stratfor Staff

Four central banks in Europe lowered their benchmark interest rates on Thursday. The European Central Bank (ECB) cut its rate by three-quarters of a percentage point to 2.5 percent, Swedish Riksbank by 1.75 points (a record cut) to 2 percent, the Danish central bank by three-quarters of a point to 4.25 percent, and the Bank of England (BOE) by 1 point to 2 percent (the lowest rate since 1951). New Zealand’s central bank also cut its rate by 1.5 points to 5 percent — a record and the bank’s fourth cut since July.

 

With investor, business and consumer confidence low across the board, these reductions are meant to spur consumption and keep the economy from weakening further. However, by dropping rates to such low levels, the Europeans are getting dangerously close to using up their last remaining policy option to encourage economic activity.

Monetary policy allows governments to adjust the supply and cost of credit in light of overall economic conditions. During times of plenty, when the economy is firing on all cylinders, restricting the flow of money by raising interest rates — that is, increasing the cost of borrowing — helps prevent inflation and the overheating of the economy. Fiscally conservative governments therefore prefer to have relatively high interest rates to offset the danger of inflation. Too much money in the system can lead to unsound investments; increasing the cost of money reduces the demand for it and thus the chance that unsound investments will be made. (Governments also can restrict the money supply by increasing the amount of cash banks are required to keep on hand.)

During recessions, on the other hand, governments try to make money cheap by cutting interest rates or increasing the amount of money in circulation, so that even the most spooked consumer or business executive is enticed to borrow and spend. Governments want to spur economic activity, so they want consumers to keep buying houses and cars — the kind of goods for which demand is determined by the cost of credit. If businesses and consumers lose confidence and curb their spending, the result can be high unemployment and lack of economic growth.

At some point, however, slashing interest rates becomes an issue of diminishing returns. A cut from 6 percent to 5 percent can make marginal projects or purchases more attractive, as businesspeople and consumers are enticed to borrow at lower costs. But cutting rates from 2 percent to 1 percent has much less of an effect: Most of the people who need encouragement to borrow for a new business project or a big-ticket purchase already will have done so by that point, because rates at 2 percent are already quite low. The danger is that the problem may no longer be the cost of capital, but rather a lack of confidence. No matter how much money a central bank might throw at consumers and businesses, it cannot force anyone to borrow or spend in times of financial pessimism. And once the rate is set at 1 percent or below, there is effectively nothing left to cut and the government has little left with which to jar investors and consumers out of their pessimism.

European central banks therefore are close to being out of options. With interest rates at these lows — 2 percent for Britain, 2.5 percent for the eurozone — there is not much cushion left. Stimulus packages will help to spur some economic activity, but should pessimism persist, the Europeans would have no other orthodox options. Japan, where interest rates are currently at 0.3 percent and borrowing is effectively free, has been in this position for years and has yet to find a way out.

The United States is in a better position because the U.S. dollar is the reserve currency of the world. This comes in particularly handy during a financial crisis — both governmental and private investors rush to buy U.S. Treasury Bills because these are considered a safe harbor during a financial storm. The U.S. Federal Reserve can essentially print money to fund a variety of credit and liquidity mechanisms to keep the overall system functioning. Such a strategy does not necessarily resolve the crisis of investor and consumer confidence, but it does give the Fed a valuable tool to grease the wheels of the economy when more orthodox methods do not seem to be working.
But for Europe and Japan — let alone the rest of the world — this strategy is simply not an option. Under normal circumstances, printing currency to pay the bills results in hyperinflation (Zimbabwe is a case in point). In any event, the Europeans have signed over control of their monetary policy to the ECB, which is treaty-bound not to print currency except to maintain the money supply.

Which means that unless the Japanese and Europeans want to be wholly at the Americans’ mercy when it comes to a recovery, they are going to have to find a different toolset for stimulating their economies. There is not much more room to lower interest rates — nor much point in doing so.

Stratfor (Estados Unidos)

 



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