What is a low interest environment?
A low interest rate environment occurs when the risk-free interest rate, usually set by a central bank, is below the historical average for an extended period. In the United States, the risk-free rate is generally defined by the interest rate on treasury securities.
Explanation of the environment of low interest rates
Much of the developed world has experienced an environment of low interest rates since 2009, as monetary authorities around the world lowered interest rates to 0% in order to stimulate economic growth and prevent deflation.
Low interest environments are believed to stimulate economic growth by making it cheaper to borrow money to finance investment in physical and financial assets. A special form of low interest rates is negative interest rates. This type of monetary policy is unconventional since depositors have to pay the central bank (and in some cases, private banks) to keep their money, rather than receiving interest on their deposits.
Like anything else, every coin always has two sides – low interest rates can be both a blessing and a curse for those involved.
Key points to remember
- Low interest environments occur when the risk-free rate is below the historical average.
- Much of the world entered a low interest rate environment following the 2008-09 financial crisis.
- Low interest environments generally benefit borrowers at the expense of lenders and savers.
Real example of a low interest rate environment
As an example, consider the interest rate environment in the United States from 1999 to 2019. The blue line represents the risk-free rate (one-year treasury bills) and the red line is the federal funds rate. . The two rates are often used to describe the risk-free rate. As the graph shows, the period after the financial crisis from 2008 to around 2020 represents an environment of low interest rates, with rates not only below historical standards, but also very close to 0%.
0% – 0.25%
The target federal funds rate from December 2005 to December 2020, marking an environment of prolonged low interest rates in the United States after the 2008 financial crisis.
Who benefits from a low interest environment?
The Federal Reserve lowers interest rates to stimulate growth in times of economic decline. This means that borrowing costs are getting cheaper.
A low interest rate environment is ideal for homeowners as it will reduce their monthly mortgage payment. Likewise, potential owners could be drawn to the market due to the lower costs. Low interest rates mean more spending in the pockets of consumers.
It also means that they may be willing to make larger purchases and borrow more, which stimulates demand for household goods. This is an added advantage for financial institutions, as banks can lend more. The environment also helps businesses make large purchases and increase their capital.
Costs of a low interest environment
Just as there are advantages to a low interest rate environment, there are also disadvantages, especially if the rates are kept extremely low for a long time. Lower borrowing rates mean that investments are also affected, so anyone who puts money into a savings account or similar vehicle will not see much return in this type of environment.
Bank deposits will also decrease, but so will the profitability of banks, as lower borrowing costs will lower interest income. These periods will increase the amount of debt people are willing to take on, which could be a problem for banks and consumers when interest rates start to rise.