In January we posted an article talking about How
“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.
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
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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Disclaimer: This Forbes Wealth Blog is for informational purposes only and does not constitute financial, legal, or tax advice of any kind. Please consult your legal, accounting, tax, investment, banking, and life insurance professionals to get precise advice relating to your particular situation before acting upon any strategy