There is a law in physics that says: For every action, there is an equal and opposite reaction. The same is true is a rate cut by the Federal Reserve. Many people get excited when the Federal Reserve cuts a key interest rate. They somehow see this as a magic bullet that is going to fix what ails the economy. They are often surprised when they don’t see an instant economic turnaround.
The idea behind a rate cut is to stimulate the economy by encouraging businesses to borrow and expand. However, people have a tendency to focus on the impact that the rate cut has in their world. They don’t see the ramifications of the Fed action to the economy as a whole. If all that was necessary to promote economic growth was to lower interest rates, why not keep them at 0%?
The good part of a rate cut is fairly obvious to most. Indeed, for many, that is all that they see. The cost of borrowing is lowered. Adjustable Rate Mortgages that are tied to short-term Treasury Bills are lowered. Home equity credit lines tied to the prime rate are lowered as well as the interest rate on many adjustable rate credit cards. One of the biggest beneficiaries is the Government itself. With trillions in debt, lower interest rates have a huge impact on the Federal Budget since so much is spent on debt service. So with all of these benefits, what could be wrong?
For everything that is good about a rate cut, there is something bad. When interest rates are lowered there is also a reduction in interest paid on fixed-rate investments. Many retirees invest a large part of their savings in investments that are perceived to be safe, such as certificates of deposit and treasury bills. When the rates are cut so are the rates on these instruments. Many senior citizens live from their Social Security and savings. When the rate on savings is lowered they find it harder to make ends meet. So a rate cut can lead to a lower standard of living for many people who can least afford it.
There are other things that happen when rates are cut. Our economy is no longer insulated from the world around us. When rates are cut the dollar falls in relation to other currencies. Since the dollar is worth less that means that the price of imported goods will rise. One of our main imports is oil. With oil already well over $100 per barrel, we can expect the price to go even higher. Since oil is such an important part of our economy, when oil rises so do the prices of other goods.
In general, lower rates mean higher inflation. What we save in interest cost we will pay back many times over in the form of higher prices. To those who are feeling the pinch of lower interest on savings, higher prices are a double whammy.
None of us has a crystal ball. There will be much pain as the current economic crisis unfolds. However, our economy is very resilient and, in time, it will recover. Much of the world depends on us to be a market for their goods and services and, therefore, need us. We have always found a way to bounce back before and I’m confident that we can do the same now. In the meantime, hang on for a bumpy ride.