CFA L3 learning notes-CME-What Happens When Interest Rates Are Zero or Negative?
LOS-And Implications of Negative Rates for Capital Market Expectations. discuss the effects of monetary and fiscal policy on business cycles
1.Impact of Monetary Policy at Zero Rates:
When the economy is in a recession and nominal interest rates approach zero, traditional monetary policy measures may lose effectiveness. In such situations, central banks employ unconventional measures like quantitative easing (QE). QE involves the large-scale purchase of high-quality domestic fixed-income securities by central banks, funded by creating an equivalent amount of bank reserves. The aim is to stimulate lending and encourage economic growth by increasing bank reserves.
2.Impact of Monetary Policy at Negative Rates:
Some central banks have implemented negative interest rate policies, where banks are charged interest on their deposits with the central bank. Contrary to earlier assumptions, negative interest rate policies have proven to be feasible.
The objective of negative rates is to incentivize businesses and individuals to reduce deposits, increase investments, and boost consumption, thus promoting economic growth.
3.Implications for Capital Market Expectations:
Negative interest rates have various implications for capital markets. Typically, long-run expected returns for risky assets such as long-term bonds and equities are based on the “risk-free rate” as a baseline, with risk premiums added. In a negative interest rate environment, the long-run equilibrium short-term rate(*) can be used as the baseline instead of the observed negative rate. However, the difference between policy rates and risk-free rates available to investors needs to be considered.
(*)(Long-run equilibrium short-term rate refers to the level at which the short-term interest rate settles in the long term under normal economic conditions. It represents the neutral or natural rate of interest that is consistent with stable inflation and full employment in the economy.)
4.Challenges in Forming Capital Market Expectations:
Formulating capital market expectations becomes more challenging in a negative interest rate environment compared to a positive rate environment. Asset prices depend not only on investor expectations of long-term equilibrium levels but also on the path taken to reach those levels. Incorporating uncertain dynamics, including negative interest rates, into finite-term capital market expectations is more difficult than projecting long-term average levels.
Monetary and fiscal policies have significant effects on business cycles in a zero or negative interest rate environment. The feasibility of negative interest rate policies remains a subject of debate, and the formation of capital market expectations faces challenges in such an environment.
01 Jul 2023 - by toptradeready.com