In response to the global financial crisis central banks across the world have cut interest rates. Why? What are the main arguments against rate cuts?

Global financial crisis is a phenomenon that brought most economies to their knees. The crisis affected the macroeconomic stabilities of countries. Investments were largely affected as both local and foreign investors were afraid of injecting their hard earned capital in an uncertain environment. Developments and economic growth of a number of economies stagnated as its citizens faced nurtured the wrath of this economic disaster. Companies laid off their employees as it sought to cut down its production costs. Moreover, banks increased their lending rates to cushion them from economic uncertainty. However, despite being faced by fear and uncertainty, central banks advocated for a reduction in interest rates. This was done to instill not only investor confidence but also that of the general public. In addition, the move was intended to trigger investments and avert further macroeconomic instabilities (Hilsenrath, 2008). This essay seeks to dissect the how central banks responded to global financial crisis by advocating for interest rates cuts.

            A central bank often plays a cardinal role in regulating credit movement in an economy. In the contemporary society, a central bank is an entity that acts with public interest at heart. In most cases, this credit regulator is often affiliated with the national government in any economy. There are a number of functions that are associated with the central bank. They include, issuing shillings and notes, acting as a lender of last resort, managing foreign receipts on behalf of the governments, acting as fiscal agent and regulating the supply of credit in an economy (Bertaut, 2002).

            However, during the global financial crunch, central banks around the globe increased their portfolio. Of most importance is that during this period, the central bank became the lender of the last resort to banking sector in a view to cushion them against systemic risk and to facilitate lending between different banks. Lending within banks can also be called interbank lending. Interbank lending enables banks to loan each other funds in the short run to enable them meet their requirements (Coyle, 2000). In banking, the rate at which these banks loan each other funds is often called interbank rate. During the catastrophic global economic crisis, fear ran through the spine of the banking sector. Here, commercial banks were scared of extending loans to each other. The aforementioned did not only result into an increase of rates but also lead to credit freezing. This freezing of credit by commercial banks forced them to request liquidity from the central bank which often acts as a lender of the last resort. According to Froeb and McCann (2009), the lack of confidence both the money market and the entire economy during the global financial crisis positioned central banks as the only lenders of not the last but the only resort. The aforementioned phenomenon drove central banks into adopting monetary actions aimed at curbing the crisis.

            At the height of the global financial crisis, central banks took rational interventionist approach to ensure that macroeconomic stability of economies is restored. For example, during the mild mortgage crisis in 1997, the Fed utilized traditional tools to relatively increase credit supply in the subprime mortgage market (Moss, 2007). During this time, Fed brought down interest rates i.e. by slashing down funds rate between zero percent to 0.25%.  In the same breath, Fed also utilized Open Market Operations (OMO) to boost liquidity in the banking sector. According to Coyle (2000), Open market operations can be said to be the buying and selling of financial instruments in an open market at relative market rates. This monetary tool that is utilized by central bank to implement policies that seeks to stabilize money in circulation. In the same breath of promoting borrowing, central banks reduced their discount rates further. Discount rate is often a rate that is relatively higher than central bank rates. The aforementioned is utilized to enhance and trigger borrowing at banks discount window. The discount window often injects commercial banks liquidity. This enables banks that are eligible to source funds from the central bank. Therefore, despite Open market Operations targeting the economy as a whole, discount window is limited to banking system that were often in need of liquidity during the global financial crunch. However, during the global economic crisis, the effects of discount lending on economies were not felt. This was relatively because banks failed to fully utilize relatively because such a borrowing sends a coded message to the market that a banking institution is facing financial problem. Therefore, at the beginning of the global financial crisis, banking institutions that were in dire need of money were very reluctant to request funds from the central bank discount window because they feared the impacts of such moves on their image. With this irrationality of commercial banks, central banks convinced some banks to acts as guinea pigs to proof to the reluctant banks that there was nothing wrong with embracing the discount window to boost their liquidity. The central bank adopted the above move with an aim of increasing the liquidity of commercial banks in order to boost their lending capabilities. In addition, they observed that the move could go a long way in cutting down interest rates further. This they asserted could have huge impact to not only the economy but also to the stock market which was already battered by macroeconomic stability (Hilsenrath, 2008).

            In conclusion, it is apparent from the above discussion that banks played a cardinal role in addressing the global financial crisis. The monetary policies adopted by the central banks were of utmost importance in restoration of confidence in the economy. Reduced interest rates ensured that credit was available to not only the investors but also common populace with much ease. Reduced rates triggered borrowing of money that was otherwise utilized to boost the macroeconomic stability of the economy. Citizens who were locked out of employment courtesy of the crisis were now able to be absorbed back by their primary employers or new employers. Investors are often keen to investing in an environment where their capital will realize most return per unit of investment. The aforementioned is achieved when there is stability of an economy. Central bank often formulates policies that are keen in controlling the flow of funds in an economy. With the cutting down of rates by the central banks, commercial banks were able to lend loans to the public at cheaper prices. This plays a major role in both the development and growth of an economy as there is a lot of money in circulation. Finally, the move by central banks to cut down interest rates boosted the stability of the stock market that was already battered by the global economic crisis.

References

Bertaut, C. (2002). The European Central bank and the Eurosystem. New England Economic Review, 25.

Coyle, B. (2000). Foreign Exchange Markets: currency risk management. kansas: Global Professional Publishi.

Froeb, L., & McCann, B. (2009). Managerial Economics: A problem solving approach. New York: Cengage Learning.

Hilsenrath, J. (2008, December). Global Crisis Resists Central-Bank Moves. Wall Street Journal - Eastern Edition, 252(144).

Moss, D. (2007). A Concise Guide to Macroeconomics: What managers, executives, and students need to know. New York: Harvard Business Press.