What is a Low Interest Rate Environment?
A low interest rate environment occurs when the risk-free rate of interest, typically set by a central bank, is lower than the historic average for a prolonged period of time. In the United States, the risk-free rate is generally defined by the interest rate on Treasury securities.
Zero interest rates and negative interest rates are two extreme examples of low interest rate environments.
Key Takeaways
- Low interest rate environments occur when the risk-free rate is set lower than the historical average.
- Much of the world entered a low interest rate environment following the 2008-09 financial crisis.
- Low interest rate environments tend to benefit borrowers at the expense of lenders and savers.
Low Interest Rate Environment Explained
Much of the developed world has experienced a low interest rate environment since 2009 as monetary authorities globally cut interest rates to near 0% to stimulate economic growth and prevent deflation.
Low interest rate environments stimulate economic growth by making it cheaper to borrow money for investment in both physical and financial assets. A special form of low interest rates is negative interest rates, an unconventional policy where depositors must pay the central bank (and in some cases, private banks) to hold their money, rather than receiving interest on their deposits.
Like anything else, there are always two sides to every coin—low interest rates can be both a boon and a curse. In general, savers and lenders will tend to lose out while borrowers and investors benefit.
Real-World Example of a Low Interest Rate Environment
Consider the interest rate environment in the United States from 1999 to 2021. The red line represents the risk-free rate (one-year Treasuries) and the blue line is the fed funds rate.
Both rates are often used to describe the risk-free rate. From the period after the 2008 financial crisis until around 2017, the United States experienced a low interest rate environment, with rates not only below historical norms but also very close to 0%.
Rates began to rise after 2017, but in 2019 started to decline again, and in 2020 fell back close to 0% due to the COVID-19 pandemic.
Who Benefits From a Low Interest Rate Environment?
The Federal Reserve lowers interest rates to stimulate growth during economic decline, making borrowing costs cheaper.
A low interest rate environment benefits homeowners by reducing their monthly mortgage payments. Prospective homeowners might be enticed into the market due to reduced costs, resulting in more disposable income for consumers. This increase in spending encourages the purchase of household goods and stimulates borrowing, further benefiting financial institutions such as banks, enabling them to lend more. Businesses also profit from lower borrowing costs, making large purchases and enhancing their capital investments.
Drawbacks of a Low Interest Rate Environment
Just as there are advantages, low interest rate environments also present several drawbacks, especially when rates are kept extremely low for extended periods.
Lower borrowing rates mean that investments are impacted, and those with savings accounts will see minimal returns. Lower bank deposits reduce bank profitability due to declines in interest income. Additionally, these periods lead to increased personal debt, potentially becoming problematic for both banks and consumers when interest rates start to rise.
Related Terms: risk-free rate, central bank, zero interest rates, negative interest rates, deflation
References
- Organisation for Economic Co-Operation and Development. “Long-Term Interest Rates”.
- International Monetary Fund. “Back to Basics: How Can Interest Rates Be Negative?”
- Federal Reserve Bank of St. Louis. “Effective Federal Funds Rate”.
- Federal Reserve Bank of St. Louis. “1-Year Treasury Constant Maturity Rate”.
