Interest rates may not be low enough to get us on the road to recovery but falling prices should help
Something strange is afoot in the economy. With interest rates at record lows in many countries, borrowing should be booming and saving on the decline but the opposite is true. This suggests that the economy remains out of kilter without interest rates being able to set the right balance between savings and investment. Instead, the shortfall in demand due to limited investment and weak spending may be dragging down prices as a means to put the economy back to health.
Not so free market
The self-healing ability of any economy is one of the central tenants of economic theory. Prices adjust as a means for the economy adapting to any changes. For example, an increase in the supply of bananas will trigger a fall in prices and more people eating bananas. A rise in companies looking for software experts would drive up their wages (the price for labour) and the number of people wanting to learn more about computers. Through changes in these prices, the economy moves toward an equilibrium where everything is at appropriate levels.
Interest rates act in the same way acting as the “price of money” to make sure that there is neither too much nor too little savings or investment. Lower interest rates are used to make borrowing cheaper and savings less worthwhile. This was the course of action taken by central banks in order to stimulate the economy by attempting to boost investment (funded by lending) and spur on more consumption (due to lower savings). Quantitative easing adds to this by giving banks more money to lend and less need to entice people to leave money in the bank.
The continued wait for a robust recovery suggests that something remains amiss. The lack of appetite among companies to expand their operations by borrowing is both a cause of and caused by weak demand in the overall economy. Spending by consumers is also faltering with people happy to let money mount up in the bank despite the low returns on savings. The high levels of household debt that still persist are another reason for consumers to hold back from spending.
The persistence of the state of low investment and high savings suggests that monetary policy has not been enough to get the economy back on the right track (although it has helped to prevent a financial collapse). A further loosening of monetary policy is not on the books for most central banks. Interest rates cannot be lowered much further considering that negative interest rates are difficult to implement. Quantitative easing also seems to have run its course while increasing creating negative side effects.
Where to next?
The inability of interest rates to adjust is hampering a return to economic growth. With interest rates not able to go any lower, it may be the case that it is prices which are instead moving to get the economy back to equilibrium. That is, rather than interest rates falling to balance out weak lending and growing savings, prices are being depressed by the lacklustre economy. The hopes for economic recovery rely on cheaper prices spurring on more spending thanks to consumers felling richer. Further impetus would result from the extra spending helping to push up investment and lift the economy to better match the current level of interest rates.
This route back to recovery may take time considering that any decline in prices will be limited and wage gains have yet to take off. There are ways to push this along of which easiest way would be for governments to temporarily increase spending. Money used for investments in infrastructure or training and R&D in new technologies would be worthwhile at a time of low interest rates. Another alternative would be for central banks to use their money-printing capabilities to transfer cash to consumers. This more radical option would provide a short-term boost to spending. Sometimes we all need a little bit extra to get us back on track and the economy is no different.