Why We Should Care About Interest Rate Cuts
Grace Watt, Staff Writer
March 13th, 2020
The words “shocking” and “surprise” can seem like paradoxes when used in the world of banking and interest rates, a steady heartbeat in the economy. However, what the Federal Reserve and the Bank of Canada did on March 3rd and 5th truly shocked and surprised the global financial community.
Albeit both banks having reassured the public that interest rates would remain stable in recent respective meetings, the Federal Reserve made an emergency rate cut the morning of March 3rd by 0.5%. Canada, whose economy is closely tied to the U.S., quickly followed suit. This signalled a global economic condition, and that there is good reason to be vigilant. Typically, federal banks hold meetings several times throughout the year to assess the current economic status of the country and to determine if, or how, interest rates should be adjusted to best serve the country’s economy. However, the Federal Reserve made this decision in between meetings, something that hasn’t been done in the U.S. since the financial crisis just over a decade ago. Banks also usually adjust interest rates by 0.25%, or similar small increments, and the 0.5% adjustment made by both the U.S. and Canada sent ripples of concern out. Both banks are very clearly sending a message, that economies could soon be headed for a downfall, and central banks are making their best attempts to get ahead of it.
While the nature and size of the recent interest rate cuts are unorthodox, decreasing interest rates are standard practice during periods when the economy is experiencing a contraction. Interest rates are the percentage of a loan that is paid back by the borrower in order to compensate for the risk of the borrow. Evidently, the higher the interest rate, the less demand there is for loans to be taken out, since it will cost the borrower more. Banks understand that people get scared during approaching recessions, and they tend to hold onto their money, for fear of the financial instability that may befall them. However, that only further drains the economy of money, and can amplify the impact of a contractionary period. In aiming to counter that effect, banks look to decrease interest rates in order to incentivize individuals into pumping their money back into the economy by an increase in spending. Often loans are taken out in order to make big purchases, such as buying a car, or finally replacing that old oven. This kind of investment put into the economy can help to jumpstart the process of moving through a recession.
During the 2009 financial crisis, this was part of the rescue plan that was employed in the U.S., when the housing market bubble burst, and Wall Street all but collapsed. At that time, the damage had already been done and interest rates were cut down dramatically to below 1% for years. Canada also cut their interest rates, although the recession was not felt as severely, and returned to higher rates much quicker. Now, with the COVID-19 virus halting crucial manufacturing abroad, global banks are worried that this is the final push towards the recession that people have been fearing.
While the Federal Reserve and the Bank of Canada have not shied away from swift, and somewhat drastic action, they also recognize the limitations of their monetary policy. Adjusting interest rates is important to the economy and is a great first line of defense during economic hardships. However, if a recession were to develop, there would not be many instruments left in their monetary toolbox. Both banks have called for the action to now come from the government, specifically fiscal stimulus plans that would help businesses and consumers to weather the storm. The Canadian government seems to have recognized this, although no concrete plans have been discussed, through the formation of committees focused on the mitigation of the impact of the coronavirus. Meanwhile, south of the border, President Trump has been seemingly reluctant for his administration to take further action. Considering he has touted a thriving economy during his administration, he is not eager to admit that the economy may need a rescue plan.
It’s clear that the Bank of Canada and the Federal Reserve have taken appropriate pre-emptive measures, if somewhat drastic, and now it’s time for politicians to do the same. America is one of the world’s most influential economies, and the global community will mimic what the U.S. endures, which means that appropriate preventive measures should be taken all the more seriously. China manufactures mammoth amounts of raw materials and partial parts that are assembled and sold internationally, making the COVID-19 virus fearsome for both economic and health reasons. If central banks are taking responsible measures to protecting the economy and its consumers, so should the government.
Ultimately, what is most feared by businesses and consumers alike right now, is uncertainty. The financial experts and economic professionals clearly are concerned about what could happen, but they are not fortune tellers. Only time will tell what comes of the global economy, but some fiscal cushioning by governments would be reassuring. The most responsible thing for politicians to do now is to prepare careful fiscal stimulus plans, in case we really do need them.