Intro: Despite the almost universal belief that central bank interest rate cuts provide a boost to the economy, most of the time they have little-to-no stimulatory effect. Rate cuts usually just reflect prior changes in the real economy’s savings/investment balance, and typically provide little insight into future growth.
The financial media is fixated on interest rate cuts and mainstream economists tend to be in agreement that rate cuts boost economic activity to some degree. However, the vast majority of interest rate cuts have little-to-no stimulatory economic impact. The main reason is that interest rate changes usually just reflect changing inflation. If interest rates fall 100bps but so does inflation, real rates of course remain the same and there is little impact on the economy overall.
Even when interest rates cuts are enacted in the absence of falling inflation so that real rates decline, the stimulatory effect on economic growth still tends to be minimal. While it is easy to look at interest rate cuts as being positive for economic growth given that they reduce debt payments and make investment decisions appear more profitable, the situation is a lot more complicated than that.
The reason is that while real interest rates may appear to be just a policy tool used by central banks to manipulate the economy, they actually reflect the real balance of saving and investment. If there is a high savings rate or a low demand for investment, all else equal, real interest rates will be low to reflect this balance. For the most part, central banks alter real interest rates in response to shifts in savings and investment, lowering them in response to increased savings or reduced investment and vice versa.
For instance, assume there is a fall in investor confidence causing a reduction in the demand for investment. In the absence of a fall in the economy’s savings rate, reduced competition for scarce savings will cause real interest rates to naturally fall, and central banks will tend to respond to market forces and cut rates. However, to argue that this provides some form of stimulus to economic growth is like arguing that falling house prices in response to reduced demand acts as a stimulus to house prices. Rather, the lower interest rates serve to merely cushion the slowdown in economic activity.
Central Banks Respond to Natural Interest Rate Decline Caused by Fall in Investment Demand
Which Helps to Stabilise Investment Drop
If, on the other hand, there is a rise in the economy’s savings rate, due perhaps from an improvement in terms of trade, interest rates will tend to naturally fall to reflect the increased abundance of savings that can be used for investment. However, the ‘stimulus’ is not caused by an arbitrary reduction in interest rates but by the increase in profitability that results from increased savings.
Central Banks Respond to Natural Interest Rate Decline Caused by Rise In Savings Rate
Which Leads to Increased Investment
To see this, imagine if interest rates are cut in the absence of a rise in the availability of savings. While businesses may see the reduced interest rate on loans as a reason to look to expand investment, the lack of growth in real savings means that their loan proceeds simply serve to bid up the price of available resources in the economy causing inflation to rise.
When Central Banks Cut Interest Rates in the Absence of Fundamental Forces, Inflation Tends to Result
Credit Growth is Not a Leading Indicator
Related to the above, it stands to reason that credit growth is generally not a leading indicator. While it seems intuitive that more credit means more ability for businesses to invest and consumers to consume, and from an individual perspective this is correct, on aggregate more money in the hands of new borrowers just reduces the purchasing power of everyone else, and the result is rising inflation and no impact on growth. Most of the time, credit growth is a lagging indicator as it reflects improvements in the economy leading to an increased risk appetite for borrowing and lending. The following chart shows the situation in the US:
