The government's decision to reduce the rate of interest on home loans may backfire and add to the current financial crisis. Interest rate reduction has been engineered to propel the housing demand, which in turn will boost the cement, steel and other related markets.
I see two caveats, which eventually may exacerbate the crisis instead of ameliorating the condition as desired.
Firstly the anticipatory reaction of the public that markets will crash further and government might further reduce the interest rates might refrain people from purchasing for a while. Opposite to what was planned, government's action might actually trigger the deflationary cycle.
Secondly banks, as all private institutions are, will never like their profits go down. Interest rate reduction will be compensated by interest rates increase in some other areas such as corporate loans. Here government's act may dispel the funds from corporate; Or increased rate of interest may not leave them any other option but to default.
I see two caveats, which eventually may exacerbate the crisis instead of ameliorating the condition as desired.
Firstly the anticipatory reaction of the public that markets will crash further and government might further reduce the interest rates might refrain people from purchasing for a while. Opposite to what was planned, government's action might actually trigger the deflationary cycle.
Secondly banks, as all private institutions are, will never like their profits go down. Interest rate reduction will be compensated by interest rates increase in some other areas such as corporate loans. Here government's act may dispel the funds from corporate; Or increased rate of interest may not leave them any other option but to default.
Government's any intervention in natural cycle may germinate undesired consequences for which we are certainly not prepared.
1 comment:
The decision makers are usually aware of such problems and try to address the issues you mentioned. However it's easier said than done.
Also whatever little awareness I have, I see two flaws in your argument: first there is already good probability of deflation so govt wants people to open their wallets. A cut in interest rates may motivate some people to buy homes; different people have different cut-offs for the interest rate at which they will buy a home.
Second I am not sure if banks would actually increase other interest rates if they have to decrease home rates. The reason being profitability is a function of interest rate as well as the amount borrowed. Low interest rates usually lead to high borrowings and vice versa; the curve between these two variables is non-linear. Hence banks figure out a sweet spot where interest rate and amount borrowed will maximize their profitability.
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