Interest Rates Cut And Rates Rise

What It Is and How It Works

The interest rate is the percentage of profitability that a financial investment generates in a certain period (usually one year), or seen from the other side, the rate on the capital that a person or company must pay when borrowing. Although each operation (each bank, each company, each family) could offer its own rate, in general they all revolve around a reference rate established by the central bank, which is the one used to lend or borrow from commercial banks. Therefore, if the Central Bank decides to “raise the rate”, it makes credit more expensive throughout the local economy; while if it lowers it, it makes it cheaper. However, the interest rate is one of those buttons that when the Central Bank touches, it not only changes a little thing, but its effects are so many that sometimes you do not know where it ends... 

The Policy’s Impact

Practically every country in the world has a Monetary Authority (a.k.a. “Central Bank”) that regulates money and its effects on the real economy. This set of measures used for such objectives (where price stability and economic growth usually stand out) make up what we call Monetary Policy. However, no Central Bank president can wake up one day and order that prices “do not go up so much”, or that the economy generates more jobs. So how does he do it? He can only do it by influencing intermediate variables, through the instruments at his disposal. At present, the interest rate is -by far- the most important instrument to develop monetary policy, and therefore economic policy in general. 

We said that interest rate movements can make credit more expensive or cheaper, but... just that? Well, not really. Because when this happens, other channels are activated that “transmit” this action to other sectors and variables. For example, if the Central Bank decides to lower the interest rate, encouraging private banks to do the same, then different households or companies that were hesitating to make an investment now find it more attractive to borrow (this may be to buy a refrigerator or a huge television in the case of a household, or to build a new factory in the case of a company). If this happens simultaneously throughout the economy, then more refrigerators, more televisions, more cement and more bricks will need to be manufactured. And then more plastic, iron, and clay to manufacture those goods. That can only be done by hiring more workers, so wow! The Central Bank reduced the interest rate a little and now we see that there are more workers. You will ask yourself: “Why then doesn't it keep lowering it until everybody is employed? Well, because as more refrigerators are manufactured and more cement is demanded, some bottlenecks begin to appear: some inputs may be difficult to increase in a very short time, or it may even be increasingly difficult to hire new labor. All this together leads to an increase in prices and an acceleration of inflation, which may result in another problem.

On the contrary, when the Central Bank decides to raise the interest rate, investments become more expensive and there is a disincentive to increase consumption or to enlarge a factory, and now it seems more profitable to use one's own money to lend it (or deposit it in the bank, which is the same thing) rather than to buy a refrigerator or enlarge the house, leading the economy to cool down.The interest rate also has an effect on the flow of capital between countries. Think of an investment fund that has to decide where to place its money: it will obviously place it in the economy that allows it to obtain a higher return (i.e. a higher interest rate). Thus, an increase in the interest rate may also allow an inflow of foreign currency from other parts of the world, while the opposite occurs when the rate is cut.

Furthermore, in peripheral economies there is another relevant channel linked to the exchange rate. Looking at the real economy, there are often bottlenecks associated with the shortage of foreign currency when imports of inputs increase. At the same time, when a Central Bank decides to lower the interest rate, many savers who previously found it convenient to lend their money in the country may now find it more attractive to offer it abroad, aggravating the shortage of foreign currency.

Stakeholders and Political Implications

As you may have noticed, interest rate changes can affect us all. However, the first to be affected are those who are making investment decisions of larger amounts. Because of their role in the system, banks are the first to be affected, although their benefits or detriments depend on each company at each moment in time. In particular, we can think that at first, interest rate increases favor creditors at the expense of debtors, while the opposite happens with rate reductions. Therefore, in general, higher rates are better received by financial and banking institutions (they tend to have credit balance), while industrial and real economy companies are better off with lower rates. If we also assume that the upper classes are those with greater saving capacity, then we can think that a rate hike is “regressive” at first, since it increases the income of the higher-income sectors. 

Some Debates Among Economists

Up to this point we have seen the most widespread view of the interest rate. However, there are discussions within the discipline regarding some of the points mentioned. Without going into them in depth, we will mention some of them.

About the existence and desirability of a “natural” interest rate: from Wicksell onwards, an important current of economic thought holds that there is a long-term interest rate that has no effect on prices or growth (i.e. “neutral”), and that this should be the objective of central banks to avoid volatility in the economic cycle. 

About the best instrument: Milton Friedman and the monetarists argue that the best instrument to control the objectives of the Central Bank is not the interest rate but directly one of the monetary aggregates (i.e., one of the variables used to measure the quantity of money in an economy). Many others argue that since private banks can also “issue money” (in fact that is what they do when they grant a loan), the Central Bank cannot control the monetary aggregates with the same power with which it controls the interest rate.

About the price anchor: If we think of the interest rate as one more cost of the price-setting companies (in fact, many of them have to finance themselves with external money to carry out certain operations), then a rise in the rate implies an increase in costs and therefore in their prices. This has led some economists, such as those of the “Sraffian” tradition, to argue that the interest rate can be inflationary. 

Real-World Examples

Federal Funds Rate History 1990-2025: https://www.forbes.com/advisor/investing/fed-funds-rate-history/ 

Japan rate rise in 2024: https://www.bbc.com/news/articles/cpqln2gwvxlo