Managing Economies in an Era of Low Interest Rates

When it comes to understanding the options available to a central bank for managing an economy where interest rates are very low, U.S. Federal Reserve Chairman Ben Bernanke wrote the book – well, a presentation paper actually, and, technically, he co-authored it, but no matter. In 2004, Bernanke –together with Vincent R. Reinhart – delivered a paper titled Conducting Monetary Policy at Very Low Short-Term Interest Rates before the Monetary and Banking Studies Lecture in Geneva. Given recent events – including yesterday’s wave of interest rate cuts that rolled across the European continent – a look at this document is most timely and could provide insight into additional actions central banks may take to deal with the global crisis.

The situation now facing the Group of Seven countries and indeed all of the world’s major economies, is that as central banks close in on a zero or near-zero interest rate policy – also known as a zero-bound policy – further interest rate cuts become impossible. Despite this constraint limiting options available to central banks, Bernanke and Reinhart discuss three other monetary tools that can be implemented even in a zero-bound economy:

1. Shaping Interest Rate Expectations
2. Altering the Composition of the Central Bank’s Balance Sheet
3. Expanding the Size of the Central Bank’s Balance Sheet

Shaping Interest Rate Expectations

The most commonly-used monetary tool used by central banks is the setting of short-term interest rates. This is because these rates impact the cost borne by commercial banks to acquire funds and this directly influences commercial rates that companies and individual consumers must pay to borrow money. Short-term interest rates also influence the valuation of longer-term assets such as equities and fixed-income bonds so in addition to directly impacting the money supply by adjusting short-term lending rates, a central bank can also influence the value of longer-term securities.

It is because of this relationship between short and longer-term interest rates, that central banks use the setting of rates as a primary monetary tool. In times of inflation, central banks can tighten monetary policy by increasing the cost of borrowing to discourage spending in a bid to ease inflating prices. When deflation is the problem and the economy needs a stimulus, central banks will pursue a policy to expand the economy by reducing interest rates to promote borrowing and, ultimately, more spending.

The current situation however, defies this conventional approach to managing the economy. Productivity is on the decline in many countries and despite deep interest rate cuts imposed by these jurisdictions which have lowered interest rates to near zero, growth is still falling. The problem now facing the central banks is obvious – having already hit the interest rate floor, further cuts are now – or soon will be – impossible.

Despite this fact, the authors point out that central banks can still use interest rates as a stimulus for the economy by offering a firm commitment to maintaining low interest rates for a longer period of time than may be otherwise expected. Such a pledge may provide the impetus needed to prompt companies and consumers to borrow and spend money now, safe in the knowledge that they will have access to “cheap” credit for the stated period of time. Bernanke and Reinhart refer to this as an unconditional interest rate commitment.

By way of contrast, the authors refer to a conditional interest rate commitment as a pledge to keep interest rates at a specific level until some form of condition is met. For instance, the central bank could commit to keeping interest rates at 0.25 percent until growth reaches at least 1.5 percent or until some other economic indicator suggests that the economy is gaining ground.

Altering the Composition of the Central Bank’s Balance Sheet

Central banks tend to hold many types of assets on their balance sheets and the make up of these assets can be used as another form of monetary tool. To illustrate how this can work, Bernanke notes that in 2004 when this article was written at least, the Federal Reserve held roughly $670 billion worth of Treasury securities with maturities from a few weeks up to thirty years, but the average maturity was in the one to four year range.

Because the Federal Reserve is a dominant force in the Treasury market, it can use its incredible buying power to influence term premiums – and ultimately overall yields – by buying securities of a certain maturity range. For example, a shift from shorter to longer-term securities could cause the value of shorter-term securities to appreciate having much the same effect as increasing short-term interest rates.

Influencing the economy in this manner, is referred to as quantitative easing and is based on the premise that a central bank – through various actions in the open market – can influence prices and security valuations.

Expanding the Size of the Central Bank’s Balance Sheet

In a similar vein, central banks – in addition to changing the composition of their balance sheet – can also alter the size or value of the balance sheet. This is also a form of quantitative easing and can be used by a central bank to directly affect the level of reserves held by the commercial banks and the overall supply of money within the economy.

This means that even if short-term interest rates are zero effectively making it free for banks to borrow money in the overnight market, impacting the availability of money can still directly affect spending levels. Thus, if the central bank were to sell securities or lower the reserve requirements commercial banks must hold on deposit, the result would be more money available for lending which is the same result a central bank desires when lowering interest rates.