Interest Rate Policy

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21 Aug, 2024

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The Interest Rate Policy refers to the monetary policy measure adopted by the central bank to impact the various economic variables within an economy by increasing or decreasing the interest rates. These variables include inflation, exchange rates, lending, borrowings, employment, investment, consumer prices, output, etc.

The rate of interest at which the monetary authority lends funds to the commercial banks or the interest rate it offers to these financial institutions on deposits influences the market interest rates, money supply, and consumer spending in an economic system. Hence, the monetary authority regulates the interest rates to control the economy.

What Is Interest Rate Policy?

Interest rate policy refers to a monetary policy tool the central bank uses to stimulate long-term economic growth and price stability in the nation by regulating interest rates.
It aims to indirectly regulate economic variables like inflation, money supply, consumer prices, employment, output, exchange rates, borrowing, lending, investing, and spending within an economy.
A negative interest rate policy is a financial policy measure considered when the economy is hard-hit by deflation and the consumers are aggressively saving money instead of investing or spending it in the market. Such a tool is employed to accelerate the slowed-down economy and job market.

Interest Rate Policy Explained

Interest rate policy is an economic measure implemented by the nation's monetary authority to ensure price stability and growth of its economy by increasing or decreasing interest rates. As known, a country's economy is regulated by its fiscal and monetary policies. The central government often manages an appropriate interest rate policy as a component of monetary policy to handle the money supply and thereby control inflation, employment level, national output, investment, borrowings, lending, consumer prices, exchange rates, and other economic variables. However, the monetary authority often aims to achieve long-term or sustainable economic growth rather than only fixing short-term economic adversities.

It is notable that when the central bank imposes a high-interest rate policy or stabilizes the rates, it is not intended to discourage investments but to direct the funds towards high-return securities. Such a strategy often works together with a tax curtailment measure. Simultaneously, a higher interest rate doesn't affect the bond issue until the issuer is reliable and the project is promising. On the other hand, lowering interest rates often prompts economic growth by accelerating borrowing and consumer spending.

While an appropriate policy ensures price stability in the long run, one cannot overlook the specific challenges of such economic measures. If the monetary authority sustains an interest rate policy for a prolonged period, it can result in inflationary pressure in the economy. In some nations like Japan, the zero interest rate policy has been persistent for a long time.

The central bank thus cannot further lower the interest rates if an economic downturn takes place. Moreover, keeping the interest rates low for the long term can also lead to the formation of financial markets or asset bubbles. It even diminishes people's savings and investments since such a market looks favorable for consumer spending.

Examples

In macroeconomic scenarios, appropriate interest rate policy serves as a critical element in the development of an economy. Let us take a look at some of such scenarios:

Example #1

Suppose country A is a developing nation with an inflation rate of 6.7%, which is too high. The prices of goods and services in the nation are sky-high, and the purchasing power of the consumers has reduced. Therefore, the central bank implements a high-interest rate policy in the country. When people are receiving higher interest on deposits, they limit their spending. Simultaneously, borrowing costs are raised to discourage further consumer spending and business investments.

Example #2

The Bank of Canada (BoC) maintained a 5% critical overnight rate, indicating a shift in its focus from elevating the interest rates to ensuring the right time for potential borrowing cost reductions. While inflation remains a concern, Governor Tiff Macklem highlighted the need to maintain the current rate. He mentioned the possibility of a rate cut but emphasized that it's too early for such discussions.

The BoC anticipates weak growth in the first quarter with a gradual pickup afterward. and expects inflation to be around 3% in the first half of 2024. This could fall to 2.5% in the second half and reach the 2% target by 2025. The BoC also continues quantitative tightening to reduce its balance sheet, although there are no signs of its ending.

Negative Interest Rate Policy

Sometimes, the central bank adopts an unusual monetary policy measure that curtails its interest rates even below the zero interest rate policy threshold. Thus, the target rate of interest becomes negative in such a condition. The primary purpose of such an implementation is to excessively ease credit availability and lower the cost of borrowing to the bottom-most extent to boost trade, commerce, and other economic activities in the country. Simultaneously, the depositors have to pay charges for keeping their money in bank accounts. This would otherwise draw them interest income.

Whenever a country experiences a tremendously falling aggregate demand (AD) due to deflation, forcing people and businesses to save money for rainy days actively rather than spending or investing it, then the central bank needs to intervene before the situation worsens. Such an economic slowdown can lead to high unemployment, business shutdown, falling output, and reduced tax revenue for the government. The negative interest rate policy (NIRP) concept was discovered in the 1990s. The goal was to serve as a last resort in exceptional economic conditions.

However, the NIRP can considerably affect exchange rates, consumer behavior, and investment choices. For example, Japan and some European states had considered a negative interest rate policy to revive their economic development after the 2008 financial crisis. Some other economies that have adopted the NIRP include Denmark, Switzerland, and Sweden, but for a short span.

Importance

Interest rate policies have been an effective mechanism employed by the central bank to deal with unfavorable economic conditions while ensuring price stability in the country. Let us discuss its significance below:

Monetary Policy Instrument: Interest rate policy is a critical component of the nation's monetary policy. It helps to achieve price stability, higher employment levels, and overall economic growth in the country.
Impacts Exchange Rates: The interest rate of any nation affects its exchange rates when engaging in foreign trade and investment, thus increasing or decreasing the value of its currency against that of other countries.
Curbs Inflation: It allows the central bank to influence economic variables like consumer spending and investment indirectly, impacting aggregate demand and inflationary pressures.
Stimulates Investment and Consumption: The interest rate policy is a tool that regulates the investing, consumer spending, borrowing, and lending activities in the nation by controlling the supply of money in the economy.
Aims Financial Stability: Central banks often regulate interest rates to ensure that there is a balance in the economy while maintaining price stability.

Frequently Asked Questions (FAQs)

Why does Singapore not use an interest rate policy?

The Monetary Authority of Singapore (MAS) has ensured the nation's sustainable economic growth by controlling the exchange rates since 1981. Singapore is a developed and stable economy that majorly relies on trade, making the interest rates highly susceptible to foreign interest rates. This is the primary reason that the nation doesn't use the interest rate policy to maintain price stability.

What was likely the Fed interest rate policy?

As of January 31, 2024, the US Fed interest rate was marked as 5.50%. However, Wall Street predicts that considering the slower pace of inflation and the job market across the US, the Federal Reserve does not intend to change the interest rates in early 2024. However, some economists believe that the Fed will likely curtail the interest rates at the beginning of 2024.

What is the zero interest rate policy of BOJ?

Japan's zero interest rate policy refers to the Bank of Japan's quantitative easing measure, whereby it entertains all the short-term borrowings while bringing down the short-term interest rates to nearly 0. The purpose is to accelerate national economic activities and trade by providing cheaper credit facilities to business entities.