Why is low and zero inflation bad

What investors should know about the era of zero interest rates

Valeria Nickel, February 5th, 2021

The situation on the capital market is exceptional: In March 2016, the European Central Bank (ECB) lowered the key interest rate in the euro zone. Since then he has been completely up zero percent.

With this decision, Mario Draghi, President of the ECB, saver not happy at all. As a result, you will receive almost no interest on bank deposits or bonds, as there is too much capital on the financial market anyway.

Exceptional situation to the power of two

The low interest rate policy is only one side of the coin: the other is currently special low inflation rate.

In 2015 and 2016, the annual inflation rate was close to zero. Since then, the inflation rate has risen slightly, but the ECB has not been able to reach the 2.0% target again in the long term. The corona crisis in 2020 caused the inflation rate in the eurozone to drop back towards zero. So there is one double exceptional situation.

Year-on-year inflation rate in the euro area from 2010 to 2020


Source: Statistical Office of the European Union (Eurostat), as of January 2021

The ECB's zero interest rate policy is not there to make savers happy

In this situation, unfortunately, it is not the job of the ECB to make households and savers happy. Your job is this Monetary policy. This includes measures that regulate the money supply and lending of the banks.

One of the primary macroeconomic goals is Price level stability. To achieve this goal, the ECB can regulate the price of money by setting the key interest rate in the euro zone.

The key interest rate, as set by the ECB, in turn depends on the inflation from, so the general price increase. This increases when the amount of money available is greater than the real supply of goods. The result is rising prices for goods. The price index for the cost of living, the Consumer price index, used. Rising prices influence the level of employment, the distribution of income and wealth as well as the economic growth of a country.

Consequences of inflation

A slight inflation of up to five percent has one positive effectas economic output grows and more jobs are created. The ECB is therefore aiming for a brand of 2,0 % at.

With a more rapid price increase, the money loses its value faster than the goods. This results in falling real wages. In this case, the ECB could raise the key interest rate so far that saving with savings accounts and bank savings plans is more worthwhile than consumption. Accordingly, an incentive would be created for money to disappear from the market and inflation to subside.

The ECB's preferred scenario does not materialize

The current is Inflation too low, however. The economy still needs to be stimulated.

The desired scenario The ECB believes that zero interest rates will increase lending, investment, consumption and, ultimately, prices. Because if there is such a small interest on deposits, then it is not worth keeping the money, just spending it.

However, it cannot be determined in advance whether a monetary policy measure will be successful. Delays in action and incomplete knowledge of the precise transmission channels of monetary policy measures make it difficult for central banks to control their ultimate goals directly.

There is a lot of wishful thinking involved in setting zero interest rates, because the The ECB can only create basic conditions, But not forcing people and businesses to borrow.

Neither can the ECB get the banks to lend. This is particularly evident in the current situation, in which banks even have negative interest rates (or penalty interest rates) if they do not put their capital into circulation but “store” it with the ECB. Nevertheless, they are not reacting as the ECB wanted. With this, the banks of the ECB thwarted their inflation forecasts right from the start.

Inflation forecasts and actual developments in inflation


Swell:

Inflation rate euro area

, As of: 25.01.21; ECB forecasts:

Onvista

, 13.02.14;

Finanz.net

, 04.12.14;

Reuters

, 03.09.15;

Onvista

, 03.12.15;

Finanz.net

, 22.01.16;

Handelsblatt

, 27.07.18;

FAZ

, 01.04.19

The general price hike occurs only slowly and so the ECB has not yet raised the interest rate again. It's a similar scenario as in Japan, where the price trend remains weak despite an extremely expansive zero interest rate policy by the central bank. At times it even fell into negative territory.

Investors need to keep an eye on the inflation rate

At first glance, inflation rates only appear to be a problem for central banks like the ECB. However, this is a fallacy. They are also of paramount importance for savers because they influence the Difference in nominal and real interest rates.

The nominal interest rate is the percentage with which interest is paid annually on a credit balance. Although it takes care of the performance of the invested capital, it says nothing about it actual profit out. As a saver, you always have to subtract the inflation rate from your nominal interest rate to get the real interest rate. This shows what a plant does after a long period of operation really worth it is.

Nominal interest rate - inflation rate = real interest rate

Most of time increases the rate of inflation over the life of a bond. That means: The purchasing power of capital is increased by exactly this percentage weakened.

Example real interest rate

If you invest € 10,000 at 3.0% interest over 10 years, you will receive a nominal profit of € 3,000 (without taking the compound interest effect into account).

But if at the same time the inflation rate is, for example, 2.0%, the investor can only use the profit to buy products worth € 1,000 instead of € 3,000. He must of the nominal interest (3.0%) the Deduct the inflation rate (2.0%): The only remaining return is 1.0%.

As an investor, you should therefore always pay attention to the difference between the nominal and real interest rates. Your investment should at least be that Balance the inflation rate again. Otherwise you will not receive any return despite positive interest rates.

Why is deflation prevented?

At first glance, the current low inflation rate for savers appears to be advantageous, since their nominal interest is not reduced. It is even questionable whether perhaps not one deflation would be good for them?

However, this is not the case with a view to the overall economy. When there is deflation, consumers know that the price is falling day by day. That is why they prefer not to buy goods today, but tomorrow. Consumption is steadily declining. Investments are no longer worthwhile for companies and production stagnates. The gross national product is shrinking and the entire economy is trapped in one Downward spiral.

That is why there is deflation never to be rated positively. The economy threatens to collapse due to deflation, as a result jobs are lost and the general standard of living falls.

For savers, one can only hope that the ECB's dream scenario will be fulfilled and that credit demand in the eurozone, and thus also inflation, will continue to rise, so that Draghi will change its low interest rate policy.

Image copyright: Yulia Grigoryeva / Shutterstock.com

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