The coronavirus (COVID-19) pandemic is not just posing an enormous risk to the physical health of millions of people around the world. It also represents a monumental economic threat that could echo the devastation of the Great Recession; or possibly even the Great Depression.
To try and mitigate the adverse financial impact, a growing number of central banks around the world have slashed their respective benchmark interest rate. However, while this move may be deemed by economists as necessary and prudent, many laypeople are confused about why lowering the rate that banks charge each other to lend Federal Reserve funds overnight should, somehow and in some way, make a positive difference in their day-to-day lives.
Fortunately, seasoned entrepreneur and executive Sanjeev Mansotra has a knack for unpacking complex financial concepts and policies into accessible, practical and easy-to-understand. He takes the time to analyze why banks are currently cutting interest rates to contain the fallout of the COVID-19 pandemic.
“Generally speaking, whenever people hear the word cut, they think of saving,” commented Sanjeev Mansotra. “For example, if a business is cutting back on its workforce, then one of the primary goals is to save costs and boost the bottom line. Or on a more consumer-friendly level, when people go to a store and see that the price of shoes is cut in half for a limited time, they clearly understand that they’ll save money if they buy now instead of later. But when central banks cut the benchmark rate, they aren’t trying to save money. Rather, they’re trying to trigger significant and rapid spending.”
The spending that Sanjeev Mansotra refers to spans across three levels: the private sector, which is comprised of business of all sizes from small firms to large enterprises; consumers, who pay less to borrow money for car loans, mortgages, to carry credit card balances, etc.; and government agencies, which have the same incentive as the other two groups — i.e. to access “cheaper” money and use it to purchase equipment, real estate, increase hiring, and so on.
“For those unfamiliar with the scale of corporate and government spending, it is worth mentioning that even a small reduction in the central bank benchmark rate — which is simply called the Fed rate in the U.S. — can be highly advantageous,” commented Sanjeev Mansotra. “For example, a large enterprise that is poised to invest heavily in digital transformation technology could save millions of dollars, simply because it’s cheaper to borrow money today or draw down a line of credit, then it was prior to the rate cut. This can and according to the central bank, hopefully does mean that instead of triggering mass layoffs, businesses will maintain their workforce size or even expand it. Of course, on a consumer level, the hope is also that instead of putting a freeze on spending, individuals and families seize the opportunity to get a new car, buy a new home, or just keep buying what they’re normally buying at the grocery store and online, because their credit card APR or HELOC interest rate will fall — thus increasing their overall purchasing power.”
With this being said, there are also some critical risks and potential drawbacks of central bank rate cuts; especially in light of the fact that rates have been at or near historically low levels since the Great Recession.
“The worry is that some central banks really don’t have the capacity to take rates much lower,” commented Sanjeev Mansotra. “They fired that bullet during the global financial crisis, and didn’t want to significantly raise rates in subsequent years for fear of triggering another recession — which may nevertheless have been the right thing to do in terms of sound fiscal policy, but not in terms of politics. However, there is some cautious optimism that reduced rates combined with quantitative easing will keep the imminent recession relatively short. That’s hardly a cause for celebration, but it does mean that worst case scenarios are unlikely to play out.”