Which best describes the effects of low and high interest rates on the economy? This is a question we received during one of our webinars this weekend, and it is not surprising that we continue to field question after question on interest rates.
We don’t blame our customers or readers for continuing to bring up these types of questions. It ‘s hard these days to not see current mortgage rates (which are indirectly tied to interest rates) being posted at the top of most websites and newspapers.
However, very few people have a complete understanding of interest rates and specifically how much they impact the general economy. We will get into this as this article progresses, but as we become more and more addicted and reliant upon debt as a society, we will be thriving or not almost entirely on the effects interest rates have on world economies.
Here we go, our answer to the question, “which best describes the effects of low and high interest rates on the economy?”
Interest Rates and How they Effect Economies
Where do interest rates come from? Interestingly enough, the shortest term interest rates are set by the Federal Reserve. According to Wikipedia,
In the United States, the federal funds rate is the interest rate at which depository institutions (banks and credit unions) lend reserve balances to other depository institutions overnight, on an uncollateralized basis.
Remember we said these interest rates were on the short side of things. And as you now know, we were talking about overnight 🙂
But what exactly is this short term interest rate? Well for starters, a company such as JPMorgan can borrow money from the Federal Reserve overnight and pay 0.75% interest on that money in interest. This is what it would look like.
JPMorgan wants to borrow one million dollars from the Federal Reserve overnight. JPM takes that million dollars and turns around and loans that money out to other businesses, insurance companies, institutions, etc., at a higher interest rate than the 0.75% they owe to the Fed.
Now, JPMorgan does own that money out overnight; however, they can lend that money out over time for much higher interest rates that 0.75%. This is the purest form of banking. Borrow money and lend it out for a higher interest rate than you borrowed it for. Pretty simple, right?
As you have probably imagined by now, there is a chain of events similar to the butterfly effect that take place after JPMorgan takes that money from the Fed and loans it out to other entities. As you have guessed, those entities take that money and do things such as operate their businesses, pay employees, invest in new talent and put milk on the shelves in the grocery store. It all, however, begins with the Fed.
Money Effects of Low Interest Rates
This one should be pretty simple as we have lived in this incredibly low interest rate environment since the better of 2009. During the financial crisis of 2008/2009, overnight interest rates were continuously decreased by the Federal Reserve in the hopes of unlocking credit and spurring growth. But how does this all work?
Let’s look at an example to show the effects that low interest rates have on economies.
We were back in 2010, and the overnight Fed Funds Rate is 0%. This means those large institutions like JPMorgan get to borrow as much money as they would like from the Fed overnight for free. They pay zero interest on that money.
JPMorgan then goes out and loans that money to ten small businesses at an interest rate of say 3% per year. Remember, JPMorgan can go ahead and do this because banks run on fractional reserve banking.
While fractional reserve banking is not the topic of this article (it is which best describes the effects of low and high interest rates on the economy?), we can take a second here and explain what is it. Fractional reserve banking, according to Wikipedia, is
Fractional-reserve banking is the practice whereby abank accepts deposits, makes loans or investments, and holds reserves equal to a fraction of its deposit liabilities. Reserves are held as currency in the bank, or as balances in the bank’s accounts at the central bank.
This definition means the bank does not need to have one million dollars in cash to go ahead and loan out one million dollars. They need something more like 1/20th of that to be able to do so.
In the case of JPMorgan taking out an overnight loan from the Federal Reserve of one million dollars, they are then able to take that money and create twenty million dollars worth of loans to small businesses. Again, because of fractional reserve banking.
JPMorgan loans that money to those small businesses at 3%. This is a small rate that a majority of solvent businesses should be able to handle. When interest rates are low, it makes access to capital much easier, meaning businesses will have more money to pay employees, expand their product lines, etc.
And this doesn’t just go for businesses. Individuals are impacted, too. The majority of people will associate interest rates with mortgages rates. They mortgage rates come from the banks. Again, if they can borrow money for close to nothing, they can lend out that interest rate for very little as well. This is why we have seen interest rates in the 3% range over the last few years because banks have not had to raise that rate to maintain profitability.
Mortgage rates being low allows for more people to be able to buy homes as a lower rate of interest. Thus, housing prices increase and everyone is a winner.
What is most interesting about mortgages rates is that mortgages rate are typically thirty years in length. But again, it is the butterfly effect where banks take our money overnight and it trickles through the system all the way to mortgages rates.
In short, when interest rates are low, it is typically met with an economic expansion. More people have easier access to cheaper money.
A High Interest Rate Environment
On the other hand, there are times when interest rates do not remain low forever and actually rise. Unfortunately, rising interest rates are usually met with financial turmoil as economies get too comfortable with such insanely low interest rates.
Let me explain to you exactly how high interest rates are usually associated with a sudden economic stand still and eventual downturn.
The Fed Funds rate is set at 4%. JPMorgan can still borrow that one million dollars and loan it out to the equivalent of roughly twenty million dollars. However, they now owe real interest on that money. JPMorgan contacts those ten businesses that they were loaning money out to previously.
Where before they were saying “Hey, we can give you up to twenty million dollars at a 3% interest rate”, they are now saying “Hey, we can give you up to twenty million dollars at a 8% interest rate.”
As you can guess, not all of those businesses are going to be able to pay back the same amount of interest they were able to before. That is a big difference in the amount of interest owed for a seemingly 400 basis point different in overnight interest rates.
Let’s say that five of those companies can continue to take loans from JPMorgan as the same size they were before. Awesome.
But half cannot. Which means half have to cut back on wages, investment, or headcount. This means that the little guy is negatively affected the most.
Consumers then are not getting raises like they used to or salaries that they used to. Because of this, they choose to spend less money. This makes other businesses cut back because they are not making the same amount of money they used to. Eventually (because there is less cheap money in the system) money stops flowing through the economy at the same rate that it did with lower interest rates.
If the above scenario happens (it always does and always will), there will be an economic slowdown. And as always, it hurts the little guy the most.
Which Best Describes the Effects of Low and High Interest Rates on the Economy?
It is pretty simple. When we are in a low interest environment, money is cheaper and easy to access by more people. This allows businesses to grow, create new jobs, and pay people more money. This allows them to spend that money (which causes inflation) and contributes to GDP.
On the other hand, high interest rate environments cause the opposite. Money is more expensive and becomes accessible to fewer people. This makes businesses cut back on spending, reduce the size of their workforce, and pay people less money. This makes individuals spend less money which detracts from growth and GDP.
One of the large problems with the extended period of zero interest rate policy is that we are very used to the free and cheap money that flows quickly through our system. People get used to spending money and buying a more expensive house because all signs point to everything being great.
However, if we use history to predict the future when interest rates rise, that all get reverted very quickly in the form of an economic slowdown and subsequent reduction of asset prices.