On the 16 December the Federal Reserve slashed its key interest rate from 1% to almost 0%, following an earlier reduction in interest rates in the UK to just 2%.
Why are Governments Lowering Interest Rates?
[Edit]These unprecedented measures are an attempt by governments to coax people to keep spending. If people started spending less money, retailers would be forced to reduce prices in an attempt to increase sales. These price reductions on a large scale, could easily produce deflation - a period of falling prices for goods, services, followed by subsequent reductions in the amount paid by employers as wages and salaries.
Why is Deflation so Serious for the Economy?
[Edit]Both the US Federal Reserve and the Bank of England regard the threat of deflation as potentially hugely damaging to the already fragile economies of the USA and the UK.
Deflation itself is not necessarily a major problem, but deflation in the context of large debt is, and right now almost everyone - from consumers, to businesses, to banks, to government - is in debt.
The Scale of Debt
[Edit]The sum of consumer and corporate borrowing in the UK right now is equivalent to 240% of our annual economic output in the UK, while US household and business debt is closer to 300% of that country's GDP. In cash money terms, that's about $45,000bn.
The alarming and important point is that if deflation were to set in, and prices were to fall, the burden of that debt would increase, prolonging and exacerbating the severe recessions that appear to be taking hold in both the US and the UK.
Will Lowering Interest Rates Work?
[Edit]The interest rates that businesses and consumers actually pay is much higher that the Bank of England or US Federal Reserve rates. This is why the Federal Reserve is trying to bring the interest rates that participants in the real economy pay to as close to zero as it possibly can, by spending hundreds of billions of dollars buying up US government debt and also loans to companies and householders, which has the effect of forcing down yields or interest rates. By the time the US central bank is finished, it will have pumped trillions of dollars into the US economy in this way. In the UK, the Bank of England is preparing to do something similar.
This process is called "quantitative easing".
Quantitative Easing
[Edit]Quantitative easing is a process that involves a country's central bank printing a lot of new money, in order to increase the supply of money. 'Quantitative' refers to the money supply; 'easing' essentially means increasing. Quantitative easing is a tool of monetary policy.
Quantitative easing was used notably by the Bank of Japan to fight domestic deflation in the early 2000s. In this case, the Bank of Japan flooded commercial banks with excess liquidity to promote private lending, leaving them with large stocks of excess reserves, and therefore little risk of a liquidity shortage.
Quantitative Easing is supposed to encourage businesses and consumers to spend rather than save, so that economic activity revives, and deflation does not occur.
Will Quantitative Easing Work?
[Edit]What is profoundly unsettling to central banks and governments is that growing numbers of businesses and consumers are opting to save rather than spend even as interest rates fall to these record lows. This is why central banks and governments are taking ever more desperate steps to stimulate growth through increases in public spending and to make money as cheap as possible.
Even if government's actions - lowering interest rates and printing more money - do prevent deflation, it is likely that at the moment global economies turn, there will be a surge in the inflation rate and prices will escalate dramatically.
At this point in time, it is likely governments would rapidly increase interest rates, to encourage people to save and spend less.
For further information see:
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