Low Interest Rate Environment Definition, Example, and Effects

What Is a Low Interest Rate Environment?

A low interest rate environment occurs when the risk-free rate of interest, typically set by a central bank, is lower than the historic average for a prolonged period of time. In the United States, the risk-free rate is generally defined by the interest rate on Treasury securities.

Zero interest rates and negative interest rates are two extreme examples of low interest rate environments.

Understanding Low Interest Rate Environment

Much of the developed world has experienced a low interest rate environment since 2009 as monetary authorities from around the globe cut interest rates to effectively 0% in order to stimulate economic growth and prevent deflation.

Low interest rate environments are meant to stimulate economic growth by making it cheaper to borrow money to finance investment in both physical and financial assets. One special form of low interest rates is negative interest rates. This type of monetary policy is unconventional in that depositors must pay the central bank (and in some cases, private banks) to hold their money, rather than receiving interest on their deposits.

Like anything else, there are always two sides to every coin—low interest rates can be both a boon and a curse to those affected. In general, savers and lenders will tend to lose out while borrowers and investors benefit from low interest rates.

Real-World Example of a Low Interest Rate Environment

As an example, let us consider the interest rate environment in the United States from 1999 to 2021. The red line represents the risk-free rate (one-year Treasuries) and the blue line is the fed funds rate.

Both rates are often used to describe the risk-free rate. As the graph shows, the period following the 2008 financial crisis until around 2017 represents a low interest rate environment, with rates not only below historical norms, but also very close to 0%.

Meanwhile, rates begin to rise in 2017, but in 2019 started to fall again, and then in 2020 fell back close to 0% due to the COVID-19 pandemic.

Who Benefits From a Low Interest Rate Environment?

The Federal Reserve lowers interest rates in order to stimulate growth during a period of economic decline. That means that borrowing costs become cheaper.

A low interest rate environment is great for homeowners because it will reduce their monthly mortgage payment. Similarly, prospective homeowners might be enticed into the market because of the cheaper costs. Low interest rates mean more spending money in consumers' pockets.

That also means they may be willing to make larger purchases and will borrow more, which spurs demand for household goods. This is an added benefit to financial institutions because banks are able to lend more. The environment also helps businesses make large purchases and boost their capital.

Drawbacks of a Low Interest Rate Environment

Just as there are advantages to a low interest rate environment, there are also drawbacks, especially if the rates are kept extremely low for a long period of time. Lower borrowing rates mean investments are also affected, so anyone putting money into a savings account or a similar vehicle won't see much of a return during this type of environment.

Bank deposits will also drop, but so will bank profitability because cheaper borrowing costs will result in a decrease in interest income. These periods will increase the amount of debt people are willing to take on, which could be a problem for both banks and consumers when interest rates begin to rise.