How Low Can Interest Rates Go? A One Minute Perspective on “Modern-Day” Central Banking Limits

Interest rates are one of the most important tools that central banks use to manage the economy. By changing the cost of borrowing, they can influence the level of spending, saving, investment, and inflation. But how low can interest rates go, and what are the limits of central banking in the modern world?

What are interest rates and how do they work?

Interest rates are the price of money. They reflect how much it costs to borrow or lend money for a certain period of time. For example, if you borrow $100 at an annual interest rate of 10%, you will have to pay back $110 after one year. Conversely, if you lend $100 at an annual interest rate of 10%, you will receive $110 after one year.

Central banks set the interest rate at which they lend money to commercial banks, which in turn affects the interest rates that commercial banks charge to their customers. In the United States, the central bank is the Federal Reserve System (the Fed), and the interest rate it sets is called the discount rate¹. The Fed also influences another interest rate, called the federal funds rate, which is the rate at which banks lend to each other overnight to meet their reserve requirements².

By changing the discount rate and the federal funds rate, the Fed can affect the supply and demand of money in the economy. When the Fed lowers these rates, it makes borrowing cheaper and encourages spending and investment. This stimulates economic activity and increases inflation. When the Fed raises these rates, it makes borrowing more expensive and discourages spending and investment. This slows down economic activity and reduces inflation.

How low can interest rates go?

In theory, there is no lower limit to interest rates. However, in practice, there are some constraints that prevent interest rates from going too low or negative.

One constraint is the zero lower bound, which means that interest rates cannot go below zero because people would prefer to hold cash rather than pay to deposit or lend money. However, some central banks, such as the European Central Bank and the Bank of Japan, have implemented negative interest rates on some of their deposits and loans, hoping to stimulate the economy by penalizing banks for holding excess reserves and encouraging them to lend more. The effectiveness of this policy is still debated, as it may also have negative side effects, such as hurting bank profitability, reducing lending margins, and creating financial instability³.

Another constraint is the effective lower bound, which means that interest rates cannot go below a certain level that is determined by the economic and financial conditions. For example, if the economy is in a deep recession, lowering interest rates may not be enough to boost demand, as people may be pessimistic about the future and prefer to save rather than spend. Similarly, if the financial markets are dysfunctional, lowering interest rates may not be enough to improve credit conditions, as banks may be reluctant to lend due to high risk and uncertainty. In these situations, the central bank may have to resort to unconventional monetary policies, such as quantitative easing, forward guidance, and yield curve control, to provide additional stimulus and support to the economy³.

What are the limits of central banking?

Central banking is not a panacea for all economic problems. There are some limits to what central banks can do and how effective they can be.

One limit is the trade-off between inflation and output. Central banks have to balance the goals of price stability and economic growth, which may sometimes conflict with each other. For example, if the economy is overheating, the central bank may have to raise interest rates to cool down inflation, but this may also hurt output and employment. Conversely, if the economy is sluggish, the central bank may have to lower interest rates to stimulate growth, but this may also fuel inflation. Therefore, central banks have to find the optimal level of interest rates that achieves both objectives, which may not be easy or precise.

Another limit is the transmission mechanism. Central banks can only affect the economy indirectly, through the channels of interest rates, exchange rates, asset prices, and expectations. However, these channels may not always work as intended, or may be affected by other factors, such as fiscal policy, structural reforms, and external shocks. For example, if the government is running a large budget deficit, the central bank may have to raise interest rates to prevent inflation, but this may also increase the government’s borrowing costs and worsen its fiscal position. Similarly, if the exchange rate is overvalued, the central bank may have to lower interest rates to depreciate the currency and boost exports, but this may also increase the cost of imports and inflation.

Conclusion

Interest rates are a powerful tool that central banks use to manage the economy. However, they are not unlimited, and they have to be used with caution and prudence. Central banks have to consider the benefits and costs of changing interest rates, as well as the constraints and limits of their actions. Central banking is an art, not a science, and it requires a lot of judgment and discretion.