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Cutting Interest Rates: Pros and Cons

Cutting Interest Rates: Pros and ConsCutting Interest Rates: Pros and Cons

Cutting interest rates is often portrayed as both desirable and an action that has little in the way of long term consequences. While there are certainly situations in which reducing the current rate of interest is helpful to the economy, it should never be viewed as a quick and simple fix that will not have some consequences at the end of the day.

The practice of cutting interest rates is something that just about every country has done from time to time. While some people believe that the action of cutting interest rates is always a good thing, that is not necessarily the case. While reducing interest rates can certainly have beneficial effects for some portions of the economy, there is also the potential to damage other sectors.

Recent directives by the Central Bank of Iran (CBI) to lower interest rates on bank deposits has instigated debates among economists and experts of different stripes on the effect of the rare move on curbing inflation and boosting production.

While most experts subscribe to the conventional economic theory that lower interest rates translate into more liquidity flowing into manufacturing which by extension augments the key production sector and helps curb inflation, some analysts hold a different opinion. The latter note that due to the unfavorable economic conditions the country is presently plagued with, money moving out of banks could possibly land in less profitable territory compared to production, like the highly controversial, inherently speculative and unproductive foreign currency and gold coin markets. Thus, the policy directed at taming inflation could actually be counterproductive only to make a bad situation worse.

 Creating Jobs

In an article published by the Persian economic daily Forsat-e-Emruz, economic expert Shakur Akbarnejad says lower bank interest rates on deposits will stimulate the stagnant job market by boosting the labor-intensive manufacturing sector.

Criticizing the banking industry, that for months has come under heavy fire from prominent economic pundits, university teachers and manufacturers, for not allocating enough financial resources for production in the past which he believes “undermined the job market and led to lower GDP growth,” Akbarnejad expressed the hope that reducing interest rates would help boost investments in production.

On more occasions than one the president and his men have announced that joblessness is a major source of concern and the top priority of the administration is to create a “business friendly” environment that will put people on the pay roll and cut the dole queues.

Recalling the prohibitively high interest rates currently charged by banks (both state and private) on loans to the struggling manufactures, he said many are finding it increasingly difficult, and maybe impossible, “to repay the debts because of declining profits, and rising costs of production emanating from, but not limited to, the western sanctions.”

Iran is under punitive economic sanctions because of its nuclear program, which the US-led western powers and the UN claim is aimed at building an atomic bomb. Tehran denies the charge and says the program is geared to the peaceful use of nuclear energy.

Noting that the 18-month-old Rouhani administration has so far managed to lower “both inflation and interest rates,” as well as “wisely control” fluctuations in the commercial markets, namely the foreign currency market, Akbarnejad proposed “letting the government move forward with its agenda without (creating) hurdles.”

 Inflation-Interest Rate Nexus  

Economist Ali Ghanbari, observing that inflation and interest rates go hand-in-hand, referred to the government’s decision to reduce interest rates as “a right and logical step in light of the fact that the government has already succeeded to bring down inflation.”

“Experience has it that lower interest rates invest more borrowing power in the hands of consumers and tend to increase investments in production, which in turn leads to higher economic growth and helps end recession,” the paper quoted him as saying.

As for the impact on lenders, he said “lower interest rates will encourage customers to seek more funds from the banks” that in turn would improve the banks’ lending operations and stimulate growth.

“Lending rates should always remain 1 to 2 percent above the inflation rate to protect the interests of depositors.”

 Not Certain

However, some analysts believe that in the present undesirable and wait-and-see economic conditions in the country it “simply cannot be claimed with a fair degree of certainty that lower interest rates would lead to higher production and more jobs.”

Economic expert, Nahid Molaee, while acknowledging the goodwill and good intention of the government to help lift production, warns that the measure to cut interest rates will have a negative impact on the profitability of lending institutions.

Noting that “some banks with a defendable track record in investment activity will be harmed with the implementation of the new policies,” she suggested that the government needs to focus on “alternate ways to encourage investment in production activities without harming the banks.”

“Banks and the production sector are not rivals. A functioning economy requires both: a dynamic production sector and a powerful banking/monetary system. One cannot and should not be sacrificed for the other.”

 

Financialtribune.com