Lower interest rates are supposed to stimulate the economy by boosting borrowing and spending. But this effect is not nearly as automatic as the business headlines would have you believe, and in the current recession, the most recent interest rate cuts seem to be having the opposite effect.
First let’s look at the ways interest rates can affect spending. With lower interest rates, it’s easier to borrow money. You need a car to get to your new job? If auto loan interest rates have declined from 8 percent to 7 percent, your monthly auto payment just fell by about 5 dollars, making it that much easier for you to buy the car. And on the other side of things, if you have lower interest rates on your credit cards, you might not be in such a hurry to pay off the balances. These two effects, on individuals and businesses, are supposed to lead to higher spending.
But at the same time, if you have money in the bank, lower interest rates mean you have less income. And this is a special concern for the millions of people who are planning to retire in the next 25 years. With lower interest rates, you may have to save twice as much money this year to keep up with your retirement savings plan. You can’t afford to spend the money now — you need to save it for later.
At the same time, lower interest rates tend to reduce the value of the currency. With low interest rates on U.S. dollars, investors are less interested in investing in U.S. dollars, and the value of the dollar declines — as it has already been doing in alarming fashion this winter and spring. And this means it costs more to buy manufactured products made in foreign countries. According to economic theory, this should lead you to buy more U.S.-made manufactured goods. But I know what you’re thinking: “What U.S.-made manufactured goods?” And low interest rates add to inflation and tend to drive up prices in general. Consumers are more likely to just buy less when they see the higher price tags.
Right now, it is very clear that the lower interest rates are not encouraging consumers to borrow. On the contrary, consumers seem more eager than ever to pay off debts. Consumers are not only skeptical about their ability to borrow in the future, they are not particularly confident that they can keep the loans they already have. Where three years ago the attitude might have been, “If something goes wrong, we’ll just refinance,” now people are saying, “What if we can never get another loan?”
This kind of consumer psychology is not so easy to overcome. An interest rate cut will not necessarily have consumer borrowers breathing a sigh of relief. Instead, that sigh of relief may come only when the loans are paid off.
For business borrowers, lower interest rates are speeding up a wave of consolidation and buyouts, leading to more layoffs. Perhaps it’s good for businesses that they can cut jobs this year instead of next, but it does not seem to be leading to economic growth.
There are times when lower interest rates are all the encouragement people need to invest in something new that helps the economy grow. This does not seem to be one of those times. The impact of interest rates on retirement savings is especially profound right now with more than half of all U.S. adult workers hoping to retire in the next 25 years. For these workers, lower interest rates and higher prices mean they have to spend less and save more, and that is not a recipe for economic expansion. In other times, lower interest rates have helped speed up an economic recovery. On this occasion, though, any further interest rate cuts will probably do more harm than good. We will have to find other ways to put the economy back together.