Interest rate cuts

Interest rate cuts are an age-old pill that is supposed to stimulate markets because the reductions make it easier for companies to borrow. Interest rates are cut in the belief that it will help revive sagging economies by creating more income, jobs and demand.

Why should I be aware of this?

Though rate cuts influence more investment in projects, businesses may not invest if there is no consumption demand.

In every society a section of the people, like the pensioners, the temporarily unemployed, those in between jobs and those who have opted for VRS, lives on the money received as interest. For this group any fall in interest rates is an immediate fall in total income, and is bound to affect the consumption ability.

Cut in interest rates fail to produce an increase in demand if there is a significant number of such people. This leads to lack of confidence, and depresses investment demand.

Overall, the unifying effect of an interest rate cut is the psychological effect it has on investors and consumers; they see it as a benefit to personal and corporate borrowing, which in turn leads to greater profits and an expanding economy.

All about interest rate cuts

While decrease in interest rate means the borrowers enjoy an interest rate cut, it also means that those who are lending money, or buying securities such as bonds, have less opportunity to make income from interest. Interest rate cuts normally prompt investors to move money away from the bond market to the equity market. Business, however gets the opportunity to finance expansion at a cheaper rate, which increases their future earning potential.

However, both consumers and investors see interest rate cuts as a benefit to personal and corporate borrowing, which in turn leads to greater profits and an expanding economy.

Boosts markets

Lower interest rates have always boosted stock markets. Locally, lower rates reduce the interest costs for companies thereby improving their earnings and stock prices. In a global context, investor funds chase markets that provide the best returns in relative turns. A rate cut reduces the relative attractiveness of debt markets prompting investors to pull out money and invest them in emerging markets that provide a higher return.

Downsides of a rate cut

The biggest downside of a rate cut is the risk of inflation. Lower interest rates are expected to prompt more spending which will pushes up prices. As lower rates force US funds to chase higher returns elsewhere, the demand for currency drops, making imports more expensive.

What can I do about it?

Review savings

Experts advise that you review your present savings and investments and ensure sure that your funds are held in the right place. Look at short-term funds differently from long-term funds. Invest short-term funds more conservatively. Investment accounts are, by their nature, riskier but should remain a part of someone's long-term investment strategy.

Buying a home or car

If you are planning to buy home, this is a great time, as prices are down, there's plenty of inventory, and interest rates are still attractive. If you need car, it is good time to invest in that too.

Move money

Moving the money you don't need for cash-flow purposes into a money-market savings account or a certificate of deposit will earn you a higher rate of interest than transactional-checking accounts.

Pay off high interest debts

First pay off the debts with the highest rates of interest and/or the ones that have the highest monthly payments. It is best to pay off credit card dues first.

References

• Investment question
• Consumption effect of interest rate cuts