The Impact of Interest Rates on the Economy and the Case for Rate Cuts in 2024

Interest rates are one of the most important tools that central banks use to influence the economic activity, inflation, and exchange rates of their countries. By changing the cost and availability of money, interest rates affect the spending, saving, and investing decisions of households, businesses, and governments. In this article, we will examine how interest rates affect the economy and why there is a need to slash them this year.

How do Interest Rates affect the Economy?

Interest rates have both direct and indirect effects on the economy. The direct effects are related to the borrowing and lending activities of economic agents. The indirect effects are related to the expectations, confidence, and wealth effects of interest rate changes.

Direct effects

• Lowering interest rates makes borrowing more affordable for both individuals and businesses. This tends to encourage spending and investment, which leads to higher aggregate demand (AD) and economic growth. This increase in AD may also cause inflationary pressures, as the demand for goods and services exceeds the supply.

• Raising interest rates makes borrowing more expensive for both individuals and businesses. This tends to discourage spending and investment, which leads to lower aggregate demand (AD) and economic growth. This decrease in AD may also cause deflationary pressures, as the supply of goods and services exceeds the demand.

• Interest rates also affect the government’s fiscal position, as the cost of servicing the public debt depends on the interest rate. Lower interest rates reduce the interest payments on the debt, which improves the budget balance and creates fiscal space for more spending or lower taxes. Higher interest rates increase the interest payments on the debt, which worsens the budget balance and creates fiscal constraints for less spending or higher taxes.

Indirect effects

Interest rates also have indirect effects on the economy through the expectations, confidence, and wealth effects of interest rate changes.

• The expectations effect refers to how interest rate changes affect the future expectations of economic agents. For example, if the central bank lowers the interest rate, it signals that the economy is weak and needs stimulus. This may lower the expectations of future income, profits, and inflation, which may reduce the current spending and investment. Conversely, if the central bank raises the interest rate, it signals that the economy is strong and needs cooling. This may raise the expectations of future income, profits, and inflation, which may increase the current spending and investment.

• The confidence effect refers to how interest rate changes affect the confidence of economic agents. For example, if the central bank lowers the interest rate, it may boost the confidence of consumers and businesses, as they feel that the central bank is supporting the economy and preventing a recession. This may increase the current spending and investment. Conversely, if the central bank raises the interest rate, it may dampen the confidence of consumers and businesses, as they feel that the central bank is restricting the economy and causing a slowdown. This may decrease the current spending and investment.

• The wealth effect refers to how interest rate changes affect the value of financial and real assets. For example, if the central bank lowers the interest rate, it may increase the value of bonds, stocks, and real estate, as the present value of future cash flows increases. This may increase the wealth of asset holders, which may increase their spending and consumption. Conversely, if the central bank raises the interest rate, it may decrease the value of bonds, stocks, and real estate, as the present value of future cash flows decreases. This may decrease the wealth of asset holders, which may decrease their spending and consumption.

Why is there a need to slash interest rates this year?

The global economy is facing several challenges and risks that may warrant a reduction in interest rates this year. Some of the main reasons are:

• The global economy is slowing down due to the impact of the COVID-19 pandemic, trade tensions, geopolitical uncertainties, and environmental issues. According to the World Bank, the global GDP growth is projected to moderate from 5.6% in 2023 to 4.1% in 2024. The International Monetary Fund (IMF) also warns that the recovery is uneven and uncertain, and that the downside risks outweigh the upside risks.

• The inflationary pressures that emerged in 2023 due to the supply chain disruptions, commodity price shocks, and pent-up demand are expected to ease in 2024, as the output gaps close and the base effects fade. The World Bank expects the global inflation to decline from 4.1% in 2023 to 3.3% in 2024. The IMF also expects the inflation to moderate in most countries, except for some emerging markets and developing economies that face persistent inflationary pressures.

• The exchange rates of many countries have appreciated against the US dollar, as the US Federal Reserve has raised its interest rate more than other central banks. This has made their exports less competitive and their imports more expensive, which may hurt their trade balance and growth prospects. Lowering interest rates may help to depreciate their currencies and boost their external demand.

• The financial conditions of many countries have tightened, as the higher interest rates have increased the cost of borrowing and reduced the availability of credit. This may constrain the spending and investment of households, businesses, and governments, especially in emerging markets and developing economies that face higher external debt and capital outflows. Lowering interest rates may help to ease the financial stress and support the economic activity.

Interest rates are a key determinant of the economic performance of a country. They affect the economy through various channels, such as borrowing, lending, expectations, confidence, and wealth. In the current global context, there is a case for lowering interest rates this year, as the economy faces a slowdown, inflation eases, exchange rates appreciate, and financial conditions tighten. By cutting interest rates, central banks may stimulate the aggregate demand, support the economic growth, and maintain the price stability of their countries.

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