<blockquote>
<p>What would be the predictable consequences of this? (I'm not talking about speculative consequences, just direct and obvious consequences.)</p>
</blockquote>
<p>Higher inflation is the most direct predictable consequence.</p>
<p>Banks would actually lower their interest rate since commercial interest rates depend on central bank interest rate.</p>
<blockquote>
<p>For example, I suppose one consequence is that banks would be able to borrow money more cheaply, but would continue to charge higher interest rates on consumer mortgages, car loans, etc, so their spread between the reserve and retail rates would increase, so banks would appear to make bigger profits.</p>
</blockquote>
<p>No this is not necessarily correct. Interest rates depend on competition and marginal costs.</p>
<p>In a perfectly competitive market banks would charge interest rate equal to their marginal cost (which is the central bank rate + little bit extra to cover operations).</p>
<p>Now of course, banks in most countries do not operate in perfectly competitive markets as they will have degree of market power. However, this just changes the pricing to be marginal cost plus some extra markup.</p>
<p>The level of markup is determined by level of competition in the market, and level of competition is (at least in short run) independent of central bank interest rate. Hence when central bank lowers its rate also commercial banks will lower its interest rate.</p>
<p>Also empirically when central bank interest rate decreases bank profitability actually declines, not increases as you suggest in your question (see <a href="https://scholar.google.com/scholar?hl=en&amp;as_sdt=0%2C5&amp;q=central%20bank%20profitability%20and%20low%20interest%20rates&amp;btnG=#d=gs_qabs&amp;t=1665667000986&amp;u=%23p%3DY3qDhM-59wgJ" rel="nofollow noreferrer">Hack &amp;  Nicholls 2021</a>). The only way how it could increase is if markup would be negative function of interest rates and that empirically is simply not true (or at least it wasn’t true in the past).</p>
<p>However, you need to be careful, nominal interest rates will often get very high when central bank battles high inflation which is usually a sign of economic turmoil. During the periods of economic turmoil banks can exit industry which can affect also level of bank competition and this markup (see <a href="https://papers.ssrn.com/sol3/papers.cfm?abstract_id=3395540" rel="nofollow noreferrer">Patrnciak 2019</a>) but that is not the effect of CB interest rate but hysteresis effect of crisis itself.</p>

CC BY-SA 4.0
2022-10-13T13:21:26.257Z
2022-10-13T13:21:26.257Z
1muflon1
<p>Obviously when inflation increases, central banks such as the Federal Reserve react by increasing their interest rates, which is what they charge their member banks to borrow money. The man of the street rails against this and demands low interest rates anyway.</p>
<p>So, let's imagine that the Federal Reserve did lower its interest rates, even though inflation was increasing. What would be the predictable consequences of this? (I'm not talking about speculative consequences, just direct and obvious consequences.)</p>
<p>For example, I suppose one consequence is that banks would be able to borrow money more cheaply, but would continue to charge higher interest rates on consumer mortgages, car loans, etc, so their spread between the reserve and retail rates would increase, so banks would appear to make bigger profits.</p>

<macroeconomics><interest-rate>
What would be the (predictable) consequences of keeping reserve interest rates low in the face of high inflation?
Lassie Fair
# What would be the (predictable) consequences of keeping reserve interest rates low in the face of high inflation?

(Asked by: username_0 on 2022-10-13)

Obviously when inflation increases, central banks such as the Federal Reserve react by increasing their interest rates, which is what they charge their member banks to borrow money. The man of the street rails against this and demands low interest rates anyway.

So, let's imagine that the Federal Reserve did lower its interest rates, even though inflation was increasing. What would be the predictable consequences of this? (I'm not talking about speculative consequences, just direct and obvious consequences.)

For example, I suppose one consequence is that banks would be able to borrow money more cheaply, but would continue to charge higher interest rates on consumer mortgages, car loans, etc, so their spread between the reserve and retail rates would increase, so banks would appear to make bigger profits.

**Tags:** macroeconomics, interest-rate


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## 1 answers

### Answer by username_1 on 2022-10-13. Score: 1

> What would be the predictable consequences of this? (I'm not talking about speculative consequences, just direct and obvious consequences.)

Higher inflation is the most direct predictable consequence.

Banks would actually lower their interest rate since commercial interest rates depend on central bank interest rate.

> For example, I suppose one consequence is that banks would be able to borrow money more cheaply, but would continue to charge higher interest rates on consumer mortgages, car loans, etc, so their spread between the reserve and retail rates would increase, so banks would appear to make bigger profits.

No this is not necessarily correct. Interest rates depend on competition and marginal costs.

In a perfectly competitive market banks would charge interest rate equal to their marginal cost (which is the central bank rate + little bit extra to cover operations).

Now of course, banks in most countries do not operate in perfectly competitive markets as they will have degree of market power. However, this just changes the pricing to be marginal cost plus some extra markup.

The level of markup is determined by level of competition in the market, and level of competition is (at least in short run) independent of central bank interest rate. Hence when central bank lowers its rate also commercial banks will lower its interest rate.

Also empirically when central bank interest rate decreases bank profitability actually declines, not increases as you suggest in your question (see [Hack & Nicholls 2021](https://scholar.google.com/scholar?hl=en&as_sdt=0%2C5&q=central%20bank%20profitability%20and%20low%20interest%20rates&btnG=#d=gs_qabs&t=1665667000986&u=%23p%3DY3qDhM-59wgJ)). The only way how it could increase is if markup would be negative function of interest rates and that empirically is simply not true (or at least it wasn’t true in the past).

However, you need to be careful, nominal interest rates will often get very high when central bank battles high inflation which is usually a sign of economic turmoil. During the periods of economic turmoil banks can exit industry which can affect also level of bank competition and this markup (see [Patrnciak 2019](https://papers.ssrn.com/sol3/papers.cfm?abstract_id=3395540)) but that is not the effect of CB interest rate but hysteresis effect of crisis itself.


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