After that impressive rant about Freddos I will now make it relevant to the current stocks sell off… eventually.
During the global economy’s almighty collapse in 2009, people suddenly had less money. This sent consumer spending sliding and therefore product demand too, leading to falling inflation and GDP. In order to halt this, central banks sought to lower interest rates. They rolled out a program of quantitative easing (QE) which involved buying up assets, predominantly government bonds. This is a bit more complicated so bear with me. A bond is effectively a loan, for example a bond may cost £100 and yield £10 after it expires in a year. This means you buy the bond for £100 and after the year is up you get this back as well as the £10 yield, so that’s a 10% return on your investment. Or in other words you’ve effectively received 10% interest on a loan that you have issued to borrower. However, the price of a bond can change, although the yield on a particular bond is fixed from its issuing. So, if the price of this bond increases to £200 due to demand, once the year is up you will receive a £10 return on your £200 investment, which is only a 5% return. Quantitative easing involves the purchasing of government bonds which increases their demand and therefore as discussed increases the bond’s price and lowers its interest rate. Now that interest rates on bonds, a form of borrowing, are reducing, this transfers to other forms of borrowing. Entities looking to borrow money can now demand lower interest rates as low interest government bonds are an option for them. So, it sets the tone for cheaper borrowing across the financial markets, in other words it lowers interest rates. There is another motivation for QE. During a financial crash, banks cut back on lending. Cash, which is essential for business function, can become scarce. Injecting some of the green stuff into financial markets by buying bonds helps to ease this.
Central banks also have a more direct control over interest rates. They can set the rate at which banks lend to one another, this is referred to as the “overnight rate”. Since a bank’s activity is affected by the rate it pays or receives from other banks, this rate trickles down to their customers through mortgage, credit cards etc. If the overnight rate decreases, it’s likely the rate of your credit card interest will follow suit if it is one that is variable. Therefore, this is another tool central bank uses to lower interest rates.