Low Interest Rates as a Trap

Trap by Wikimedia Commons
Trap by Wikimedia Commons

On January 20th, 2009, the Bank of Canada announced that it was decreasing its target for the overnight rate from 1.5 per cent to 1 per cent. The announcements of the intention to maintain the rate at 1 per cent has been repeated ten times now. Economists do not believe that the next decision, set for March 8th, will be any different. When we look at the table of world interest rates, we can see that a policy of low interest rates has undertaken central banks almost all across the developed world.

Why So Low?


When the economy is weak, people and businesses hesitate to borrow money. Demand for loans decreases, and this negatively affects the cost of loans. Moreover, a sleepy mortgage market slows down the housing sector, which often plays an important role in economic recovery. By lowering interest rates, central banks hope to stimulate the economy. Low rates encourage people and businesses to take a loan so that spending will rebound and the economy will be on its way again. It seems to be a great solution, but it has also its dark side.

Not Working Well in the U.S.

Bank of Canada is maintaining low
interest rates despite country’s high
personal debt. The main reason are
dark prospects of global economy’s future.

Lowering interest rates hurt those whose income depends on interest rates (such as retirees and investors), as they earn less. They in turn spend less, and the economy suffers further. The Fiscal Times describes Julie Moscove’s situation. She has watched her monthly interest income drop from more than $2,000 a few years ago to perhaps $400 now thanks to the monetary policy of FED. “It’s ridiculous,” says Moscove, who’s semi-retired but still runs the Tattoo-A-Pet registry business. “I cut coupons now.”

The positive effects usually overshadow the negative, but in the U.S., it hasn’t work as usual. U.S. citizens are already indebted and do not intend to borrow more. They owe more on their mortgages than their houses are worth, so they can’t sell their homes and buy new ones. Renting has become a new trend, and banks have tightened lending standards, so new homeowners may not qualify to gain a loan. Still, the low interest rate policy probably saved the U.S. economy from getting worse.

Canada is Borrowing

Debt by Daniel Lobo
Debt by Daniel Lobo

Canada is a different case. Interest rates have truly supported lending money, and now, Canada’s personal debt raises some serious concerns. The record level of the debt-to-income ratio (151 per cent) is not actually so dire a sign. However, a report from CIBC World Markets Inc. shows that Canadian borrowing has surged over the last five years and has been driven by the most indebted households.

“Some 34 per cent of households that have debt are now in the high-debt-burden category and they account for nearly three-quarters of household debt outstanding,” says Avery Shenfeld, Chief Economist at CIBC, co-author of the report.

Low, Lower, Lowest… What Now?

After years stuck at near-zero interest rates, there isn’t such a strong effect. Those who wanted to borrow have already made their decision, so the effectiveness of the stimulus is decreasing every day. It would support lending money if the rates dropped even more. But how can they when they are almost at zero now? Negative interest rates, so rare in international banking history, can be described as a tax on holding money, so it is not reasonable in these conditions. However, if central banks decided to increase their rates despite the dark prospects of the global economy, it would discourage potential borrowers and likely have a serious negative impact on our economy. Banks are therefore caught in a trap.

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