Interest Rates Cannot Go Lower Than Zero

After the December 16, 2008 announcement from the U.S. Federal Reserve, we now know how low interest rates can go. It should now be clear that any investor who has not yet panicked should be panicking now. By signaling to the world that the Federal Reserve is prepared to lower interest rates to zero (or very close to zero), the Federal Reserve is indicating that the economic situation in the U.S. is much worse than many previously thought.

Since the U.S. accounts for approximately 30% of world economic output and 50% of global equity markets, the situation bodes poorly for the rest of the world as well. China and Japan, for example, both need a healthy U.S. economy to sell their exports, and other countries around the world are affected by what happens in these countries by the complex ties that modern globalization brings.

The effects of a steadily slowing U.S. economy on the global equity markets are clear. The MSCI all country world index (which can be traded using the ETF with ticker symbol ACWI), for example, is down a previously unheard of 44% for the year to date. The ACWI ETF has rebounded off of its November, 20 2008 low, but it is still too early to confidently predict a global equity market recovery.

In normal times, lowering interest rates are usually the most direct route to stimulating the economy because monetary policy has a faster impact on the economy than does fiscal policy. The problem is that when interest rates get too low, a whole new problem emerges that prevents lower interest rates from having much of an impact on the economy. The problem is that a "liquidity trap" develops.

A liquidity trap refers to an economic situation in which people prefer to hold cash rather than make loans. Abnormally low interest rates occurred in the United States during the late 1930s and in Japan during the late 1990s. For a recent example of just how bad things can get, turn to the economic situation in Japan. In December of 1989 the Nikkei 225 index closed in on an all time high ofclose to 39,000.

Since then, the Nikkei index has experienced a slow steady decline and most recently the Nikkei 225 closed at 8,600. The Japanese economic situation in the 1990s is often referred to as the "L" recession because a chart of economic growth resembles the shape of the letter L. Basically, economic activity dropped off dramatically in the early part of the 1990s and Japan wrestled with one recession after another for a good ten year period. The Bank of Japan did lower interest rates down to the point that nominal interest rates where very close to zero but the lower interest rates failed to stimulate the economy. Fiscal stimulus was enacted, but to no avail. The world’s second largest economy would not respond.

Critics of Japanese policy makers like to point out that perhaps the Bank of Japan did not move fast enough to lower interest rates, or that the Japanese government did not move fastest enough to use fiscal stimulus.

No matter, because monetary or fiscal stimulus only work on expanding the economy when consumers have the money and confidence to respond. In the case of the United States, interest rates (or at least the Federal Funds rate) have been decreasing since September of 2007 when it was 5.25%. The problem is that either the low interest rates are not being passed on to consumers in the form of cheaper loans or consumer confidence is so low that borrowing money has become less attractive.

Moreover, according to the National Bureau of Economic Research, the U.S. economy has been in a recession since December 2007. There are just too many bad economic events happening at the same time.

As a result, lower interest rates are very unlikely to provide a magical fix to the economy. Going forward, it is probably best to hope for U.S. economic policies promoting slow stable monetary growth combined with fiscal expansion focused on new job creation.

By most accounts, the first half of 2009 has been written off as one of slow economic growth combined with more job cuts. Since equity markets tend to turn before general economic indicators, somewhere in the next few months a signal should emerge as to what kind of economic recovery we can expect.

Comments

[DiggerUK:]

The net effect of 0% rates must surely mean that you are buying money at less than cost, if inflation stays above zero.
Do the maths, if you borrow now and inflation devalues money, the repayments get steadily easier.
A Zimbabwean who borrowed 1 Million 10 days ago could easily repay that ammount today, and be left with the change.
In a deflationary time of course it would be the opposite.
Whatever one thinks of Fed/Cental bank actions, you have to admit it's bold to move to 0% rates.

2008 Dec 18 08:44 AM

[OldLimey:]

DiggerUK: "Whatever one thinks of Fed/Cental bank actions, you have to admit it's bold to move to 0% rates."

There are only a couple of things scarier than a 'bold' central banker, and one of them is the underlying reason why boldness is required.

2008 Dec 18 11:10 AM

[DiggerUK:]

British understatement dear boy, British understaement.

2008 Dec 18 11:47 AM

[neutrino23:]

Just a theoretical point but why can't rates go lower than zero? Instead of a contract to repay principal plus alpha after some period of time you write a contract to repay principal minus alpha after some period of time. Basically you pay people to borrow money.

2008 Dec 19 04:05 PM

[DiggerUK:]

When rates are below inflation, then you pay negative interest.
With rates at zero, and inflation positive, you are paying negative rates.
Any maths Professors out there who can check my formula?


On Dec 19 04:05 PM neutrino23 wrote:

> Just a theoretical point but why can't rates go lower than zero?
> Instead of a contract to repay principal plus alpha after some period
> of time you write a contract to repay principal minus alpha after
> some period of time. Basically you pay people to borrow money.

2008 Dec 20 10:28 AM