What do interest rates tell us about the state of an economy?

Question

I seem to have a misconception about what interest rates mean. On one hand, they signal how high a government's demand for money is, because if a government is ever in any serious need of money, they can sell bonds with a high enough coupon rate to ensure that investors will quickly buy them, which will have the knock on effect of raising interest rates. On the other hand, I hear that government will frequently increase/decrease interest rates in order to discourage/encourage consumer spending (although, frankly, I've got no idea how the governments go about changing these rates).

So, put bluntly, what do interest rates actually mean? If we take for example the UK, I've never heard anyone claim that the interest rates are low because the government is in no real need of money, but I have frequently heard that the interest rates are low because the government wants to encourage consumer spending. What should be read in to that?

Answer 1

What do interest rates tell us about the state of an economy?

Very little. That is because interest rates are a mechanism aimed at influencing one of many variables of an economy, rather than to diagnose it/them. Interest rates are a one-dimensional dimensional parameter, whereas the state of an economy cannot be captured with just one number.

For instance, an economy might be analyzed from the standpoint of its GDP, its Gini coefficient, income per capita, inflation, an agent's (or sector's) purchase power parity, and other aspects which are not comparable to each other. A rate simply cannot describe all these aspects.

Your question itself reflects how interest rates are used for purposes which are not necessarily --or not always-- related: to aid governmental budget, and to influence consumption. In some situations, a cash-strapped government might wish for a reduced consumption (for instance, to be able to cope with public demand), whereas in other situations it might wish for greater consumption (to increase its tax revenues). The fact that two variables in an economy don't always go -or are not intended to go- in the same direction illustrates the ambiguity of how to interpret interest rates.

It should be added that interest rates are also a mechanism aimed at procuring currency stability. This goal can be at odds with patching a budget so that the government can fulfill its agenda. Hence the importance, at least among those of us with a neoliberal mindset, of keeping government and central bank separate; that is, to ensure that the latter is an autonomous entity.

Answer 2

I am going to focus on the use of the term "low". How low?

If firms and the private sector perceive interest rates as low enough, they will choose to take out loans and buy goods and services. They weigh their opportunity costs and their expected ROI on whatever it was they intended to buy. However, even "historically low interest rates" may not be low enough to stimulate this behavior. There is no magic number at which this occurs. If the economy's outlook is extremely bad, it may be the case that even an interest rate of 0% is not low enough to stimulate this behavior.

As a result of this general tendency, though, investors tend to predict an increase in consumption and investment when interest rates decline. When interest rates increase, they expect decreases in those same categories.

Answer 3

In the UK (and most developed countries), interest rates are not changed by the government but by the central bank via the Monetary Policy Committee (MPC). This means decisions are made independent of direct government intervention and are hence not affected by political myopia. The MPC makes changes to the interest rate primarily to influence inflation (to keep inflation within target). The interest rate can be changed in 2 main ways:

1. The MPC can lower the base rate which is the cost of borrowing for other commercial banks from the central bank. If the base rate is increased then this will most likely be passed on by commercial banks to consumers causing interest rates to rise.

2. Increasing the money supply through quantitative easing. This is a process by which the central bank buys up financial assets such as government bonds in order to increase the cash deposits of commercial banks and other financial institutions. This increases the money supply and hence lowers interest rates as shown on the diagram.

The interest rate represents the cost of borrowing and the reward for saving. Lowering the interest rate would make it cheaper to borrow encouraging investment and it would reduce the return on saving raising consumption. Also, cutting the interest rate would increase hot money outflows (short term cash flows from foreign investors looking to earn the highest interest). This would cause a depreciation in the exchange rate leading to a rise in demand for exports and fall in imports. Overall, this would raise aggregate demand causing demand-pull inflation. (Raising the interest rate would have the opposite effect)

Hence, when economic growth forecasts are low due to a lack of confidence in the economy, the MPC is likely to lower interest rates in order to stimulate increases in demand. For example, after brexit the Bank of England reduced interest rates to 0.25% because uncertainty was high. This was aimed at encouraging spending, as you said, to prevent a fall in demand which would reduce inflation and have negative knock on effects on the rest of the economy. However, the interest rate is set in anticipation of the inflation rate in 2 years as it takes time for the effect of a change in interest rates to ripple through the economy. Therefore, it may not be very representative of what the economy is going through at a given point in time.