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Financial scenarios 30 Sep 2019

How do interest rate cuts impact the economy?

Mounting trade tensions and the fear of a potential global slowdown have recently caused central banks to rethink their strategies. Some have even kicked-off a new round of interest rate cuts. What’s the goal?

With the start of the new session, the European Central Bank announced a comprehensive set of accommodative monetary measures, and days later the Federal Reserve lowered interest rates.

Generally, monetary policy is used to keep inflation near a specific target or within a defined range. Still, an economy’s interest rates — or the price of money — can also have a direct impact on economic growth. 

A low interest rate environment improves financing capacity, for consumers and businesses alike, as well as for the government and public institutions. Consequently, lower interest rates incentivize both consumption and investment and, at the same time, offset a drop in imports stemming from a depreciated foreign exchange rate. By contrast, the devaluation of money favors those companies that have business abroad: those businesses will be more competitive, and as a result, will see increased exports. 

Meanwhile, when a central bank decides to increase interest rates, what it usually intends is to contain inflation and stabilize prices. So, the ECB raises interest rates in times of economic expansion, because this is when there is the greatest risk of inflation (with greater demand, prices rise.)

Ultimately, interest rate manipulation is a tool that can either inject strength into the economy or avoid its overheating.

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