Understanding the role of interest rates

In a week action-packed with top-tier events, it is almost too easy to forget that three major central banks are scheduled to deliberate on their underlying monetary policies. The Federal Reserve in the US, the Bank of England, and the Reserve Bank of Australia are expected to maintain their near-negative interest rates unchanged, as the second global downturn deepens.

All of the anticipation and uncertainty revolving around the outcome of the US Election has somewhat overshadowed the role interest rates are going to play in the future road to recovery. Yet, the current moment is as good as any to explain the exact function interest rates play in contemporary economic theory. One can contemplate on the broader economic cycle, as underpinned by John Maynard Keynes's seminal work – The General Theory of Employment, Interest and Money, by drawing an intriguing parallel.

If you have seen HBO's award-winning 'Chernobyl' series, you would remember the trial scene in the last episode. Professor Legasov is asked to explain how an RBMK reactor works, so using red and blue panels on a board he summarizes the primary processes taking place within the reactor. Essentially, reactivity, which creates power, either goes up or it goes down, while the plant operators need to maintain balance. Accordingly, uranium fuel causes reactivity to go up, while boron control rods are used to reduce reactivity.

So, what is the connection of all of this to finance and economics you might very well be asking? Well, Legasov's model could just as easily be repurposed to expound the role of interest rates.

If the role of a nuclear power plant is to produce energy, then the inherent purpose of economics is to promote well-being and growth. It follows then that in our repurposed model, reactivity's role is substituted for economic activity – the more of it there is, the more growth is generated. Central banks mirror the part, perhaps unsurprisingly, of plant operators within our broader narrative, while the function of uranium fuel is compared to the role of interest. More fuel in the reactor is synonymous to a dovish monetary policy, while the lowering of the boron rods is compared to a hawkish stance by a given central bank.

Just like reactivity in an RBMK reactor, general economic activity would continue to grow uncontrollably, provided that all underlying factors remain the same. While on the surface, unimpeded growth seems highly desirable, things are not as clear-cut as they seem.

Low-interest rates boost economic activity, just like uranium fuel induces reactivity. They reduce borrowing costs, which in turn deters investors from putting their money in a bank, as the overall savings rate depreciates. Instead, readily available borrowing capital promotes heightened investments and consumption, which lead to surging inflation. Bear in mind that hyperinflation in our model has the same detrimental consequence that xenon has in Professor Legasov's – its build-up over time threatens to blow up the entire cycle.

When left unchecked, low-interest rates would continue to increase aggregate demand, which would then fuel (the word is chosen carefully here) growth, while inflation rises steadily. The result is a self-sufficient cycle that Keynes referred to as the accumulative effect. Yet, we all know that hyperinflation leads to economic bursts and subsequent recessions, which is why our economic reactivity needs to be put in check by central banks.

When inflation shoots above a given central bank's target level, the Governing Council of that bank is compelled to increase the underlying interest rate in order to prevent such bursts. As these monetary policy rods enter the economic reactor's core, the cost of borrowing goes up. Consequently, savings are increased, while consumption and investments are slashed. As a result, the growth rate is slowed down, but more importantly, adverse inflation is reduced.

This brings us to the current state of the global economy, which is characterized by its historically low-interest levels. This year's major economic downturn caused a severe disruption to global growth, which is what prompted central banks to action. By slashing interest rates, they intend to restart the cycle by reinvigorating aggregate demand, and boosting consumption and investing.

Even though this strategy is completely sound in its logic, it is not without its risks. The massive levels of liquidity could indeed promote growth, but the looming danger to recovery stems from the possibility of sudden surges in headline inflation.

Remember when the energy output in the reactor started jumping out of control seconds before the explosion? Well, this was the result of the build-up of xenon in the reactor core. Since in our model, we established xenon to be representing high inflation, in economic terms, this means that the historically low-interest levels could lead to future problems if mishandled.

While there is no immediate danger at present, if you start hearing about inflation levels above 2 per cent being "not great, not terrible", perhaps it will be time to start looking for the financial equivalent of a lead protective costume.