Over the last several years, many of our clients who prefer to hold significant amounts of cash for unplanned emergencies or near-term purchases–as we frequently recommend–have benefited greatly from higher interest rates.  After many years of ultra-low interest rates, these clients have finally been rewarded with respectable returns on their cash holdings.

Others seeking to purchase a house or car were not so fortunate.  For these individuals, borrowing costs often made financing far less attractive and limited buying capacity, given that inflation had already taken a toll on pricing.

Now that the Fed appears poised to begin a rate cutting cycle, we thought it may be interesting to take a brief look at how interest rates affect the economy.  As you will see, the impact of interest rates is quite extensive:

1. Borrowing and Spending

• Increased Borrowing: Lower interest rates reduce the cost of borrowing. Individuals may be prompted to consider a new house or car, while businesses might contemplate expanding or other capital improvements.
• Higher Consumer Spending: Reduced loan rates mean lower monthly payments, which can often free up money for consumers to spend on other goods and services.

2. Investment

• Business Investment: With lower borrowing costs, businesses are more likely to invest in new projects, equipment, or expansion. This can lead to job creation and increased productivity.
• Stock Market: Lower rates often make bonds and savings accounts less attractive compared to stocks, potentially driving up stock prices and increasing wealth for investors. At CAM, we know that equity investors will often benefit, while fixed income investors may not be as pleased with their returns.

3. Housing Market

• Increased Home Buying: Lower mortgage rates can make buying a home more affordable, potentially boosting the housing market and increasing home values.

4. Exchange Rates

• Weaker Currency: Lower interest rates can reduce the value of the national currency, often leading to lower returns on investments denominated in that currency. As a result, exports can become more cost effective and more competitive abroad, however, the goods we seek to import often become more expensive.

5. Inflation

• Potential for Inflation: Increased spending and investment can drive up demand, potentially leading to higher prices and inflation. However, the actual impact on inflation depends on other factors, like supply chain conditions and overall economic capacity.  Keep in mind, the rate-hiking cycle was implemented to curtail rising inflation.

6. Savings

• Lower Returns on Savings: Lower interest rates reduce the returns on savings accounts and fixed-income investments, which might discourage saving and encourage spending or investing in riskier assets.

7. Bank Profitability

• Pressure on Banks: Lower rates can squeeze bank profits, as the difference between what banks pay on deposits and what they earn on loans narrows.  As the spread diminishes, so do the expected returns on financial institutions.

8. Economic Growth

• Stimulating Growth: By making borrowing cheaper and encouraging spending and investment, lower rates can help boost economic growth, especially in periods of economic slowdown.  Although some stocks may seek some contraction in Price-to-Earnings, the overall effect on the equity markets is typically positive.

9. Debt Levels

• Increased Debt: Easier borrowing conditions might lead to higher levels of household and corporate debt, which can pose risks if rates rise in the future or if economic conditions change.  While lower rates can make new purchases enticing, we always encourage our clients to remain within the guidelines established by their plan.

10. Long-Term Implications

• Asset Bubbles: Prolonged periods of low rates can sometimes lead to asset bubbles if investors take on excessive risk in search of higher returns. At CAM, we routinely caution our clients to allow their risk tolerance, objectives and time horizon to determine their level of exposure.
• Policy Limitations: In the future, if the economy needs stimulus again, the Fed might have less room to maneuver if rates are already low.

Interest rates can have far-reaching impacts on the economy and investors seeking returns, whether in the form of appreciation or yield.  There are both upsides and downsides to lowering rates, a balance that must be carefully managed to support growth, while curtailing inflation.   The equilibrium should not erode all interest in savings, but should reward investors who seek to allocate at least some resources equity investments.

If you are questioning how lower rates may have on your investment strategy or your financial plan, please let us know.  We will gladly model several scenarios to help you better understand the impact for you personally.  We will also gladly help you evaluate the benefits of refinancing any existing loans.