The Federal Reserve in Washington
The Federal Reserve in Washington. World's leading central banks have been quick to cut interest rates in response to the COVID-19 outbreak. Throughout history, pandemics have been charting the long-term course of interest rates, more effectively at times than financial crises. Image Credit: Reuters

Covid-19 will have a lasting impact on the global economy and on its financial order. This can be said because of the connection that has evolved over time between pandemics and interest rates, where the occurrence of the former results in lower levels of the latter.

Throughout history, pandemics have been charting the long-term course of interest rates, more effectively at times than financial crises. The historic connection, which has been established in a working paper by the economist Paul Schmelzing, may be evolving again with Covid-19.

Let’s first consider what central banks would normally resort to when faced with an economic slowdown, whether caused by a problem in the financial markets or by a black swan event like Covid-19. Primarily, the main tool used is the lowering of interest rates to increase liquidity in the markets.

Whereas the tool is still being used today to a certain degree, others have become widely available as well. Such tools include changes in the Reserve Ratio (RR), which is the amount of cash that commercial banks are required to always maintain. The use of monetary tools, in response to financial and pandemic-induced crises, has also delved into negative interest rate territory, in effect an extension of the interest rate tool.

Moreover, another modern-day remedy has been the pioneering of what came to be known as Quantitative Easing (QE). A few of the above-mentioned tools were also used to target inflation itself rather than interest rates, with mixed results to show for it.

A necessity

Either way, the interest rate curve began to flatten out for a good number of economies as they kept on lowering their interest rates post the 2008 Global Financial Crisis (GFC). As a consequence, the response to Covid-19 had to be different, more out of necessity than out of choice.

Governments started throwing good money after bad at the problem, with positive results far from being conclusive as most economies grapple with the health, financial, and economic ramifications of Covid-19. Governments with the capacity to lower their interest rates went ahead and did so.

Others resorted to lowering their RRs too. The ultimate target was higher liquidity in the inflected economies.

Did that work, though? Not really.

Immune to more rate cuts

The world has been in this ultra-low, negative interest rate terrain for quite some time now. Thereby, and theoretically speaking, the world must already be awash with liquidity, which in turn should have stimulated demand by businesses and individuals. That is not the case, however, which is due to three reasons.

One, and in association with the historic connection mentioned earlier between pandemics and interest rates, businesses and individuals are weary of consumption at times of uncertainty. This creates its own drag on interest rates and on economies, regardless of what level central banks want interest rates to be at.

Not only that, individuals are more inclined towards saving rather than consuming in times of crisis, a problem that higher market liquidity cannot deter. This is why a few governments, like Denmark’s, moved away from traditional liquidity targeting through financial systems to securing jobs through salary subsidies, thus safeguarding and stimulating businesses and individual consumption.

Two, consumption itself has moved away from traditional means to non-traditional means, with online shopping becoming the highlight of changes in consumption patterns when Covid-19 first started spreading in China. As bricks-and-mortar shops and businesses suffered because of lockdowns and lack of demand and consumption, online businesses were thriving.

Three, the 2008 GFC has left both businesses and individuals with higher debt levels than before the crisis. The lowering of interest rates that followed encouraged higher levels of borrowing, and that undermined any further effect that additional lowering of interest rates could have on demand and consumption.

A reset

The 2008 GFC has forever altered the relationship between interest rates — thus liquidity — and consumption.

In conclusion, pandemics have been setting the direction for interest rates over the past centuries. The relationship between consumption, liquidity and interest rates is no longer as simple as previously perceived, which led to the ineffectiveness of attempts by central banks to increase liquidity levels.

While the 2008 GFC is partly to be blamed for that, the change in consumption patterns, from traditional to online, has also played a role. This is why governments resorted to nonconventional approaches this time, including direct subsidisation of salaries.

The last thought that I want to leave you with: What will happen to Small and Medium Enterprises (SMEs)?

— Abdulnasser Alshaali is a UAE based economist.