What do lower interest rates do to the economy? How the Economic Machine Works

The Federal Reserve is in a cycle of lowering interest rates, but what does that mean and how does that impact the economy?  In last week’s article we described what really happens when the Federal Reserve lowers interest rates.  We learned that interest rates on things we buy, like houses and cars do not necessarily go down just because the Federal Reserve lowers the Federal Funds Rate.  If you did not get a chance to read that article you can find it here: https://www.cedarstoneadvisors.com/post/investing-basics-what-does-it-mean-when-the-federal-reserve-lowers-interest-rates

This week we continue in the same theme, but with a reminder of how interest rate changes impact the economy.  I recommend the video by Ray Dalio “How the  Economic Machine Works”: https://www.youtube.com/watch?v=PHe0bXAIuk0 Yes, it is 30 minutes long, but it does an excellent job explaining how interest rates impact the economy.  

If you do not have time to watch the video, allow me to provide a quick summary.  The economy is essentially the sum of countless transactions by people like you and me. We make buying decisions in part based on the cost of debt. For example, if interest rates are higher, say on a new car that we would like to buy, then we must buy a less expensive car to get the same payment. This same concept applies to just about everything purchased with debt:  apartment buildings, computer equipment, airplanes, inventory…just about everything. Higher interest rates, therefore, make everything more expensive, slowing consumption and investment.  Conversely, lower interest rates provide a boost to economic activity by lowering the cost of borrowing.  

The Federal Reserve uses higher interest rates to slow the economy when inflation becomes too hot and lower interest rates to stimulate the economy when there is a risk of a recession and job losses.  For the last several years the Federal Reserve has been raising rates to fight inflation.  Now that inflation has been declining they are finally at a stage of lowering interest rates, which is generally good news for stocks.

I hope you enjoy the video!