Interest rates cut – what does it mean?
Monday 13th April 2020
As the economic impacts of coronavirus began to take hold, central banks around the world reacted with a range of monetary policy measures. [Monetary policy is that policy adopted by the monetary authority of a country. Policies could include changing the central bank’s interest rate or controlling the money supply by issuing currency.] In March 2020, the Reserve Bank of Australia and US Federal Reserve cut the base interest rates in their respective countries to 0.25%. Also in that month, the Bank of England cut its base rate to the same level, before further reducing it to 0.1% – the lowest in the Bank’s history.
Central bank interest rates are a key indicator as to the state of the economy and a key monetary policy tool used to control economic stability. The base rate is the interest rate applied to funds deposited with/charged on funds borrowed from the central bank. The depositors or borrowers in this situation are other banks – commercial banks, for instance. The central bank base rate therefore influences the interest rates applied by the commercial banks to their products, including savings deposit accounts, mortgages and other loan products. Interest rates are therefore often defined by some, simply, as ‘the cost of borrowing and the reward for saving’. Considering these aspects in turn allows the basic effects of interest rate changes to be understood.
Firstly, the cost of borrowing is reduced by an interest rate cut. Interest is, after all, paid by the borrower on borrowed funds. A reduction in the interest rate therefore reduces costs. In times of economic crisis, this reduces the relative cost of financing for businesses, which should enable them to continue to meet their financing needs by having an available supply of cash that can be accessed at a more affordable rate. This should enable the business to continue its activities with more regularity than if this financing were not available at the new, lower cost. More broadly, this should reduce the need for businesses to cut costs elsewhere by, for example, making employees redundant. A major increase in unemployment due to this, especially during a time of economic crisis, will only worsen the situation for the wider economy.
For consumers as well, a reduction in the cost of borrowing can have benefits. For those with outstanding debts, repayments may decrease (with the interest component being lower). For homeowners, mortgage repayments may also be lower through the same logic. In addition to the lower costs, these consumers will consequently have a greater level of disposable income. If their spending therefore increases, across the whole economy, this could help stimulate economic growth – reducing the severity of an economic downturn or helping with the recovery. It should be noted, however, that those with debts on a fixed interest rate basis (such as mortgages with a fixed interest rate for a period of, for example, 3 years) will thus not feel the benefit of an interest rate cut in that respect in the short-term.
Secondly, a cut in interest rates reduces the reward for saving. It is often said (in simple terms) that we have a choice to either spend or save. If interest rates are cut, the reward for setting money aside in a savings account is lower. This should incentivise consumers to instead spend more of their money. Across the whole economy, a rise in consumer spending will help maintain economic growth or reduce the extent of a downturn – both crucial at times of economic crisis.
There are, however, a number of caveats to this basic assumption that need to be borne in mind. In relation to the assumed choice between spending or saving, it should be remembered that some people (particularly those who are retired) rely on their savings as their source of income to then spend. A reduction in interest rates paid on their savings may thus reduce their ability to spend. Further, this effect of a central bank rate cut actually reaching consumers is conditional upon the banks holding consumer deposits cutting the interest rates on their savings accounts. If they do not, then the above effect will be far less potent. Additionally, the expected rise in consumer spending here may not occur if consumer confidence in the economy is low – particularly during times of economic crisis and/or recession. If consumers feel their long-term financial security will be best protected by building-up their savings, they may do this rather than increase spending – in spite of the reduced interest rates offered on savings deposits.
This has been a summary of some of the key impacts that recent cuts in interest rates (theoretically) may have on the economy. In practice, as with any economic theory based upon models, inherent uncertainties exist and so the results of any given monetary policy decision cannot be guaranteed. Furthermore, it is important to also take into account the wider economic context – including fiscal policy responses from the government, as well as other monetary policy responses such as quantitative easing [where the central bank introduces new money directly into the economy’s money supply].
