Big discounts on money

Interest rate drops or rises are not a subject that the reader is quick to click on the news button for. Nonetheless, the issue – cost of money – affects us in our daily lives both directly and indirectly. When we buy a home using a loan, we want the bank to take the smallest possible chunk out of our wages. When saving money, by contrast, we want the deposited amount to generate as much additional revenue as possible. The impact of low interest rates is currently being felt by borrowers and depositors alike. The arduous recovery, low demand and overall uncertainty following the economic crisis have forced central banks to take vigorous action in order to stimulate their respective economies. Central banks, which shape monetary policy, have lowered interest rates, reaching 4 to 5 per cent before the crisis, to virtually zero levels. As is well known, monetary policy decisions of central banks affect the entire financial world, as a result of which the effective interest rates paid on debt obligations have reached very low levels nearly everywhere. Several economic analysts, however, have pointed out that the decline in effective interest rates, allowing for inflation, has been occurring over a significantly longer period, indicating that the reason cannot be the financial crisis and central bank policy alone. Why have interest rates fallen, and how does it affect us?

Why have interest rates fallen?
There are several competing explanations for why interest rates have fallen. One of the main explanations is a concept introduced into the public consciousness in 2005 by the previous head of the Federal Reserve, Ben Bernanke: savings glut. As with goods, the cost of money, too, is driven by supply and demand. If at some point the desire of people and companies to save exceeds their wish to consume and invest, the interest paid on debt obligations will decline due to competition. A study recently published by the leading economic think tanks ICMB and CEPR[1] also identifies the most important factor in increased savings rates, influenced in turn by demographic factors. With improved medicine and standards of living, people’s life expectancy has been growing rapidly, whereas the average retirement age has remained unchanged. This means that, once retired, people have to make do with their accumulated savings over a significantly larger number of years, which has increased people’s inclination to save. Saving has been boosted also by another demographic factor: the share of middle-aged people in the total population. In their younger years, people’s income is usually limited, yet goes up as their age increases, peaking in mid-life. Given the increased share of middle-aged people in the total population, saving has grown as well. A significant impact has been also China’s integration into the global financial markets. In China, with its weak social protection system, the need to get by during ‘rainy days’ has caused people to set aside a large portion of their incomes. The one child policy has decreased the supporting role of the family, forcing the Chinese to save even more. Because of open financial markets, this has had a considerable impact on interest rates in other countries as well.

In the aftermath of the economic crisis, fear and uncertainty have left their mark on interest rates. Households, which were handed some hard lessons, have set about saving even more diligently, also in Estonia, where the value of private individuals’ deposits are increasing significantly faster than the volume of loans. Furthermore, companies are cautious in making new investments, increasing the disconnect between the supply and demand of money. Additional pressure is being exerted by the decreased risk appetite of those saving/investing. Demand for secure investment options, that is, bonds with high ratings, has led to a situation where investors are willing to pay a premium for them in order to ensure the preservation of their money.

What is the impact of low interest rates in Estonia?
How low interest rates are impacting Estonia’s financial sector is analysed by the Bank of Estonia in its most recent Financial Stability Review. In the estimation of the central bank, low interest rates are affecting in particular the revenue earned by banks and insurance companies. The lion’s share of loans issued in Estonia have floating interest rates, which in turn are most often tied to the 6-month EURIBOR. As EURIBOR declines, revenue earned by banks decreases. However, interest rates also affect the cost of money for banks themselves, as manifested, for instance, in lower deposit interests. Insurance companies are vulnerable for the reason that their assets are mostly invested in long-term bonds, on which interest revenue earned has decreased significantly.
Low interest rates have also been blamed for creating a hotbed for property bubbles. In countries where peoples’ participation on financial markets is high, low interest rates on debt obligations are prompting people to take higher risks in the form of bonds or shares with dubious value. In Estonia, there is little possibility for taking these risks due to the less-developed capital market and low investment activity there. Nevertheless, attractive loan terms coupled with rapid growth in wages may threaten the stability of the property market. Fortunately, the situation remains quiet for the time being.

Are low interest rates here to stay?
In the assessment of CEPR’s analysts, however, there is no reason to think that the current trends will continue forever or that effective interest rates will remain at levels this low. In many countries, also nominal interest rates are near zero, and effective interest rates could fall only due to higher inflation. Several forces that have caused effective interest rates to drop are likely to change direction in the future. A large number of middle-aged households with high saving rates are about to reach retirement age and will start consuming their accumulated savings. Also the influx of Chinese savings onto the global financial markets is slowing down, as China’s export-oriented economy is turning towards an economic model based on domestic consumption. The big question that remains is the horizon for when interest rates will be recovering, since in this central banks and governments have their say through monetary and financial policies.


Mihkel Nestor
Economic Analyst, SEB
 

Evelin Allas
Communications Manager
Marketing and Communications Division
SEB
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