Why do Central Banks reduce Interest Rates?

Many countries around the world are currently reducing interest rates in order to influence their economies. But how does reducing interest rates affect the economy and how does it affect us as wealth builders?

Interest rates are one of the most powerful tools that central banks, like the Federal Reserve or European Central Bank, can use to control the economy. One of the main objectives of reducing interest rates is to prevent or reverse an economic slowdown by stimulating spending and investment as lowering interest rates can significantly influence everything from consumer spending to business investment, housing markets and even influence the stock market.

Let’s take a look at each of the possible affects and how they affect different aspects of the economy.

1.       Encouraging Consumer Spending

When central banks reduce interest rates, borrowing money becomes cheaper. For individuals, lower interest rates on loans such as mortgages mean that people are more likely to borrow more money.

Financial pressure can be eased with lower interest rates as variable rate loan payments get cheaper, and when people have more disposable income available because they’re paying less on loan interest, many are very likely to spend that extra money. This increase in consumer spending can boost demand for goods and services which in turn can stimulate businesses to produce more (economic principle of supply and demand at work!).

The increase in spending aims to create a ripple effect throughout the economy.

2. Boosting Business Investment

Businesses, much like consumers, also benefit from lower interest rates. When it’s cheaper to borrow, companies are more inclined to take on financing at lower rates which makes expanding and improving operations, like new facilities, hiring employees or expanding operations, more financially viable.

This increased business investment can lead to higher productivity and job creation. In turn, with more people employed and earning wages, consumer confidence rises, which drives further spending.

3. Supporting the Housing Market

One of the most direct impacts of lower interest rates is felt in the housing market as lower mortgage rates make buying homes more affordable. When monthly mortgage payments decrease, more people can afford to purchase homes which boosts demand in the housing market.

The increased demand can raise home prices, which benefits homeowners through higher equity values. For homebuilders, an increase in demand for housing can lead to increased construction activity, which, in turn, contributes to economic growth and job creation in sectors related to housing such as real estate, construction and home improvement.

4. Lowering the Cost of Debt

Lower interest rates reduce the cost of both personal and corporate (company and business) debt. Individuals with variable-rate loans or credit card balances benefit from reduced interest payments, which frees up more of their income for saving, investing or spending.

For governments, lower rates can ease the burden of servicing national debt. A reduction in interest payments on debt allows governments to allocate more resources to other sectors of the economy such as healthcare, education or infrastructure without needing to raise taxes or cut spending.

5. Stimulating the Stock Market

When interest rates fall, fixed-income investments like bonds typically offer lower returns. As a result, investors may seek higher returns by moving money into the stock market. This influx of investment can drive up stock prices, benefiting companies by increasing their market value and making it easier for them to raise capital.

Higher stock prices also boost the wealth of investors, potentially increasing consumer confidence and spending. In what’s known as the "wealth effect," people who feel wealthier due to rising stock portfolios are more likely to increase their spending (although we don’t recommend that here as you don’t actually have the money until you sell your shares and you shouldn’t spend money you don’t have).

So, the Central Banks are looking to stimulate the economy, but does reducing interest rates have any negative impacts?

6. Impact on Inflation

One of the main objectives of reducing interest rates is to prevent or reverse an economic slowdown by stimulating spending and investment. However, increasing demand can also lead to higher prices for goods and services, potentially causing inflation to rise.

Central banks typically monitor inflation closely when adjusting interest rates. If inflation begins to rise too quickly, they may respond by raising interest rates again to slow down the economy. Therefore, while lowering interest rates can help an economy recover from stagnation or recession, it must be balanced carefully to avoid inflationary pressures.

7. Weakening the Currency

Another consequence of reducing interest rates is that it can lead to a depreciation of the national currency. Lower interest rates make investments in that country less attractive compared to nations with higher rates, reducing the demand for the currency in foreign exchange markets.

A weaker currency can benefit exporters, as it makes goods and services produced domestically cheaper for foreign buyers. However, a weaker currency also means that imports become more expensive, which could drive up costs for consumers and businesses that rely on foreign products or materials.

8. Encouraging Risk-Taking

Low interest rates often encourage investors to seek out riskier assets to achieve better returns. This "search for yield" can push more money into stock markets, real estate and other speculative investments which can potentially lead to asset bubbles. While this can drive short-term economic growth, it also introduces risk if asset values become inflated and eventually crash, as seen in the 2008 financial crisis.

Conclusion

Reducing interest rates is a critical tool used by central banks to stimulate economic growth during periods of sluggish activity or recession. By making borrowing cheaper, central banks encourage consumer spending, business investment and housing market activity.

However, lower rates can also increase inflationary pressures, weaken the national currency and encourage risk-taking.

Ultimately, the aim of lowering interest rates is to balance stimulating growth, prevent an economic slowdown whilst maintaining control over inflation. Central banks must carefully monitor economic indicators to adjust interest rates effectively and avoid long-term imbalances in the economy.

By understanding how interest rate changes affect various economic sectors, both businesses and individuals can make more informed financial decisions and anticipate the broader impacts on the economy.