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Ultra Loose Monetary Policy and Its Effects on the Behavior of Investors and Businesses

Updated on September 22, 2017
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Ultra Loose Monetary Policy : When did it all begin ?

When the 2008 financial crisis occurred, the world was in panic. With financial markets in a meltdown, governments were forced to rescue the banks with taxpayers money. After the international financial system has been stabilised, the economy has been damaged. With the 2008 financial crisis haunting banks, banks started cutting down lending activities This in turn harm the economy as businesses could not obtain the credit needed for them to make investments. Without credit or debt, another different problem : Low economic growth.

With economic growth rates hitting rock bottom, Central banks across the world started engaging in Ultra Loose Monetary Policies such as lowering of interest rates and engaging in Quantitative Easing (QE) where the central banks would purchase government bonds ( i.e government debts) or other financial assets in a bid to spur the local economy. The logic is that low interest rates would lower financing cost i.e the cost of obtaining loans and would spur banks to lend more and businesses to borrow more while Quantitative easing would ensure that the financial markets has more money which in turn boost liquidity and would add an element of stability to the financial markets.

With Lower interest rates and more money floating around the financial market, many governments and central banks hope that these would be the key to jump start growth in the economy.

Side effects on Behavior : Investors

When central banks enacted these policies, the consequences for the financial markets were huge. Lower interest rates and QE has caused yields on government bonds to fall meaning that investors would enjoy lower returns if they were to invest in government bonds. As government bonds are seen as a riskless investment, it often are bought by many investors as sign of stability meaning that they could enjoy return without taking on any significant risks.

However, with yields declining, many investors were left searching for higher return in the financial markets. This incentivized them to shift their money from government bonds to other financial assets such as equities, corporate bonds ( company issued debts) and etc. These assets are more volatile due to their higher risk profile. This in turn presented the central banks with a paradox : Central banks were suppose to stabilize the financial markets, but the implementation of QE and low interest rates has instead incentivized investor to take on more risk taking therefore raising the total risk in the financial markets.

Another consequence of QE and low interest rates is the building up of financial bubbles in different classes of assets. With low record rates on the horizon, investors has shifted a huge amount of money from bonds to other financial assets due to their appetite of chasing higher returns. And this in turn increase the value or price of that financial assets which is beneficial to the investor .Sometimes, the investor would overlook the economic fundamentals of the financial assets they invest . What happens when investors do not fully analysed the fundamentals and just invest in a financial asset just for the sake of enjoying higher returns ? Overvaluation or financial bubbles would occur as price or value of the financial assets does not fully reflect the underlying economic fundamentals.

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Side effects on Behavior : Businesses

When the 2008 financial crisis seem like an Armageddon moment for economies and businesses worldwide, central banks were the ones to step in and save the day. Like the saying with each crisis, comes an opportunity. With record low interest rates on government bonds, firms figure out that they would find no shortage of investors into their own bonds (which pays a higher rate ) in a low interest rate environment. This has created a phenomena where firms would issue more debt in order to take advantage of lowering financing costs.

These seems to be a good idea in the first place. Firms could utilize the money to invest and expand their business which is good for the growth of economies. However instead of using these funds for operations and business purposes, many firms use the funds obtained from raising debt to engage in stock buybacks. As such many question the effectiveness of the low interest rates where the funds provided to the firms is not being circulated in the real economy ( i.e purchasing machines , investment into new factories and human resource & training).

As many know, the root cause of the 2008 financial crisis was the economy’s excessive debt levels that were unstainable to the point of collapsing the world’s economy. With firms engaging in even more borrowing from the markets, it seems that they too are taking more risk themselves as they cash in on the low financing costs provided by the central banks policies. This would in turn further diminished the prospect of economic growth. As firms become more debt laden, their ability to make future investments as they need to pay more of their profits and revenue to interest payments on the debt that they have taken. This in turn would be a drag on any future economic growth.

Conclusion

The world economy has been saved by the quick intervention of central banks worldwide. In the aftermath of the 2008 financial crisis, ultra loose monetary policy such as QE and low interest rates have restored stability in the financial markets. However,continues to pose certain hazards to the financial market.

Even though debt was coined the evil at the height of the crisis, ultra loose monetary policy continues to impact the behaviors of both investor and businesses that would could pose further dangers and risks to the world economy in the future.

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