The Effects of Lower Interest Rates on the Economy

Base interest rates, as set by the Federal Reserve on a routine basis, are a very important component of the economy, and the more our economy depends on borrowing, the more important those interest rates become. Over the past decade, our interest rates have been among the lowest in our history. Put in the simplest terms, interest rates make it cheaper to borrow money, which means more people are encouraged to spend and invest more money. The extra spending and investment increases demand and spurs economic growth. This increase in demand may also result in greater inflationary pressures.

According to basic economic theory, lower interest rates should also reduce the incentive to save, since interest rates determine the amount of interest savers receive periodically and lower interest rates mean a smaller return on their savings.

Regardless of the theories that most seem to believe, though, when dealing with the real world, the issue of lower-then-normal interest rates seems less cut0-and-dried.  more complicated. The link between interest rates and saving is not clear because many factors affect saving.

Consider what's happening now, for example. Since 2009, the household saving rate following the economic meltdown was 0.5%, but has since risen to more than 8%, even though the key interest rate has dropped significantly in that time and have stayed that way. In 2009, key rates were still just above 5%, while now, they hover around 0.5%. This may be because attitudes changed, and the fear of recession and massive unemployment became greater than the need for a larger return on savings.

When interest rates are low, the reward from saving money is also low. That means it is somewhat more attractive to hold cash and/or spend money. This is the substitution effect – with lower interest rates, consumers substitute spending for saving, since it doesn’t seem to matter if they save money or not. By the same token, when interest rates fall, some savers see a decline in income because they receive lower income payments. A senior relying on interest payments from saving may feel he needs to save more to maintain their target income from savings.

The substitution effect usually dominates because the lower interest rates make saving less attractive. However, for some the income effect may dominate their thinking and they may respond to lower interest rates by saving more as a way to maintain their standard of living. One reason the stock market did so well after the Great Recession is because former savers bought stocks as a way to get a better rate of return than they can get in a bank or even on bonds.

Usually, a cut in Federal Reserve base rates leads to an equivalent fall in bank rates, but following the last recession, bank rates didn’t fall as much as base rates, which is one reason why the cut in base rates didn’t have as much impact as expected. The reduced incentive to save represented by the bank rates has encouraged consumers to spend rather than hold onto money for little or no benefit.

Of course, because lower interest rates mean cheaper borrowing costs, consumers have felt encouraged to take out loans to pay for greater spending and more investment. The continued low mortgage interest rates, for example, have reduced the monthly cost of mortgage repayments, which means homeowners can afford to buy a bigger house and they will have more disposable income, which they can spend on consumer goods. Lower interest rates means it is far more attractive to buy large assets (like a house or a bigger car), which leads to an overall rise in home prices. Low rates also make it more attractive to take out a second mortgage to make improvements in an existing home. That means people don't have to wait until "they can afford it" to make their home worth more. The increase in wealth that results from easier borrowing also pushes consumer confidence higher, which keeps the economy strong.

There is another aspect to maintaining low interest rates that makes it very attractive, and that is the depreciation of the exchange rate. If the U.S. Federal Reserve reduces interest rates,  it makes it relatively less attractive to save money in the United States, and it also makes U.S. exports more competitive and imports more expensive, which also helps push aggregate demand even farther forward.

Not all interest rate cuts are passed on to consumers. When the Federal reserve cut the base rate during the last recession, banks had the option of not passing the rate cut on to consumers and many of them opted not to, as a way of encouraging more mortgages, car buying, and other large purchases.

The Impact of Low Interest Rates on Different Demographic Groups

Lower interest rates are good news for those who want to borrow large amounts of money, especially homeowners and small business owners. While they are also bad news for those who wish to savers, especially retired people and others who depend on their savings for a living, the U.S. economy is largely dependent on borrowers. Also, the "American Dream" involves owning a home and the auto industry is still the crown jewel of what is left of our manufacturing economy, so inexpensive lending and borrowing is a very important aspect of our economy.

On the one hand, lower interest rates encourage consumer spending, which means an interest rate cut will create a corresponding increase in spending on imports, which will cause a deterioration in the current account.

However, lower interest rates should cause a depreciation in the exchange rate. This makes exports more competitive, and if demand is relatively elastic, the impact of a lower exchange rate should cause an improvement in the current account. Therefore, it is not certain how the current account will be affected.