Interest Rates: Cuts are Not the Answer

In January we posted an article talking about How High Interest Rates Might Go. It looks like we may have hit that ceiling, as interest rates were cut in the US by 0.25% in late July. Many were still not happy with the cut as they hoped the Fed would slash rates by 0.50%. Now the public and the president are calling for larger rate cuts. However, is lower interest rates really what we need?

“A lower interest rate doesn’t make debt go away.”

Dave Ramsey

Historically, since 1955 the average federal fund rate has been 4.88%. Currently, it is 2.25% and people are still calling for more and expecting the federal reserve to lower it.

The Federal Funds Rate is the interest rate that banks and financial institutions lend reserve balances to each other, overnight, on an uncollateralized basis.

Cutting Interest Rates

Interest rate cuts are not a new phenomenon. They have been happening for decades. Historically, when the economy would enter a downtime, the federal reserve (or BoC in Canada) have cut rates to try and spur market activity and encourage borrowing.

Lower interest rates mean cheaper access to money. Cheaper access to money leads to more business investment and consumer spending. Cutting interest rates incentives spenders and penalizes savers.

When rates get cut, it incentivizes people to take on more debt (because everyone needs more debt). During rate cut cycles, people buy houses, cars, and businesses expand, pushing the economy higher.

So, if lower interest rates equal a better economy, why not set them near 0% or even negative?

0% interest Rates?

Although super-low or even negative interest rates sound awesome, there are several reasons we don’t have them and why they won’t help.

First, low-interest rates are good for the consumer and spur the economy. However, in the long term, they are bad for lenders. With low rates, lenders are not being compensated fairly for the risk they are taking on.

In the long term, it even has negative consequences for the consumer. In low interest rate environments this generally means higher consumer debt and a lower savings rate for consumers. So, what happens when an extended period of low interest rates ends, and rates begin to rise? Consumers can no longer afford their current debt payments and have nothing saved to help fill the gaps. Consumption slows or even stops.

Second, low interest rates haven’t always been the norm. As we said earlier, the average since 1955 is 4.88%. Times of easy money (when rates are low) were rare, and people would use those times to make more significant purchases or “investments”. But easy money has been the norm for quite a while now leaving no reason to hold off on larger purchases. Here is a list of federal funds rates over history.

Think of interest rate cuts as a sale.

Lets say there is a sale on a new TV. Instead of $1,999 it is being advertised at $999. Sounds like a good deal. A lot of people would be interested in buying it, especially if it was only available for a limited time, and limited quantity.

However, what if the store had the sale sign, but you know that you can get it for the same price down the road. They are advertising a sale but in reality, it is the new price of the TV.

This is similar to interest rates. We are being told they are “on-sale”, only 2.25%. But we are smarter than that. We know they have been at relatively the same level or lower, for more than a decade now. Sounds like a pretty long sale to me.

Third, the economic growth that rate cuts do provide is somewhat artificial. The economic growth only lasts as long as the rates are low. Once rates go up the economic growth that was created starts to taper off.

Therefore, dropping rates likely won’t have the same effect as it has had in the past.

Even if we ignore all these facts, cutting interest rates still doesn’t make sense.

What’s different about the rate cut this time around?

We are constantly being told that the economy is growing, that we should continue to be bullish, and that the only way is up… Well, the feds current actions contradict that pretty clearly.

If the economy was in a healthy state, and growth was on the forefront of everyone’s mind, the fed wouldn’t need to be cutting rates. Historically, cutting rates has been reserved for stock market crashes and other bad economic times. So maybe, they know something we don’t? Or maybe they know nothing at all…

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