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A view on low interest rates and the transmission mechanism

Cape Town - In monetary economics, the transmission mechanism is the process through which the monetary policy decision, short term interest rate changes or asset purchases, affect the real economy.

It is believed that economic variables such as the price level (inflation) and economic growth can be controlled via the transmission mechanism.

The transmission channel can be theoretically explained with various flow charts and arrows that link monetary policy, or the interest rate decision, to the real economy.

A basic graphical illustration of the transmission mechanism will look like the following:

From the figure it can be seen that the central bank can influence the economy by the setting of the central bank rate. In South Africa this rate is called the repo rate.

When economic growth and inflation are weak, the central bank will lower the central bank rate, which in turn will lower the bank rates, increase asset prices and weaken the exchange rate. These factors will lead to an increase in the money supply which theoretically stimulates growth and inflation.

In Europe, countries are experiencing inflation rates that are either zero or negative. Germany has a CPI figure of 0%, Spain -0.8%, France -0.2% and Italy -0.3% just to name a few. Economic growth is also struggling to recover.

With no inflation and no economic growth, the European Central Bank is trying to use the transmission mechanism process to kick-start economic growth and inflation by cutting interest rates across the Eurozone and expanding its Quantitative Easing (QE) programme to €80bn per month. These interest rate cuts have been used by the ECB since the financial market crash in 2008.

The graph below shows how the ECB benchmark rate has been cut since 2008.

With rates on a downward path since 2008, we are yet to see inflation and a pick-up in economic growth. Despite all the ECB's best efforts, deflation and low economic growth are still a concern. It is worthwhile to start investigating the various channels of the transmission mechanism to see if the linkages are in fact working. Let’s look at the linkages found in the flow chart:

Bank/Market rates: With the ECB benchmark rate at zero, commercial banks' profit margins are forever decreasing; lowering the incentive to lend money to the mainstream economy. Add to that that after the 2007/08 financial crisis, commercial banks have become very stringent on the credit criteria of their borrowers. Hence, only a selected few will be able to access borrowed funds from European commercial banks.

Asset Prices: As mentioned, lower interest rates should lead to an increase in the general price level. However, with banks not lending out the “stimulus” money created by the ECB to the mainstream economy, the only price inflation has been seen in the stock market. The German Dax has increased by 188% since September 2009.

Expectations: Perhaps the most important channel of the transmission mechanism process is the management of expectations. If the main economic participants (business and government) do not expect that the policies are going to have the desired impact, it won't.

Exchange rates: The low rates and excess supply of capital should weaken the euro. The weak euro will help exporting companies. Although the euro has considerably weakened against the US dollar, it is more dollar strength than it is euro weakness. With world economies also lowering their respective interest rates, the euro has remained relatively strong against all other countries

As we can see from the above, the ECB's efforts to stimulate the European economy hasn’t been all that successful. Perhaps it is time for central bankers to relook the linkages in the transmission mechanism. What they will do regarding the linkages are yet to be seen. One school of thought is that central banks will write off the government debt racked up during the quantitative easing programme.

It is possible as they technically borrow from themselves. Another school of thought is to move away from the Keynesian approach to a more free market approach, letting the economy self-correct without intervention. This may very well be the road to take.

* Kirk Swart is a director at Overberg Asset Management (OAM), an authorised financial services provider (No 783) which specialises in the private management of local and global discretionary portfolios as well as pension products.

Disclaimer: The above article does not constitute financial advice and is not a recommendation. Investors must always seek the advice of professionals and trade with caution. Under the ECT Act and to the fullest extent possible under the applicable law, Fin24 disclaims all responsibility or liability for any damages whatsoever resulting from the use of this site in any manner. 

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