What Happens When a Central Bank Cuts Interest Rates?

Central banks have shifted into a rate-cut mode in 2024. After slashing rates to 3.25% in September, they went forward with further reductions in December 2024, lowering the benchmark rate by 0.25 percentage points. This aggressive stance has been driven by concerns over slowing economic growth, subdued inflation, and geopolitical tensions. 

Central banks aim to stimulate borrowing, investment, and consumer spending by easing monetary policy, ultimately revitalizing the global economy. This blog will discuss the impact of such rate cuts on the economy and investors.

Why does the central bank cut rates?

Central banks cut interest rates to stimulate economic activity during periods of slow growth or economic downturns. When interest rates are lowered, it becomes cheaper for businesses and consumers to borrow money. 

For businesses, this reduced cost of borrowing encourages investment in capital projects, expansion, and hiring. At the same time, consumers are more likely to take out loans for expensive items like homes and cars or increase their spending on goods and services. This surge in borrowing and spending helps boost the economy's demand, leading to increased production, job creation, and overall economic growth.

Lower rates can also lead to a depreciation of the national currency, making exports cheaper for foreign investors and stimulating economic activity.

However, while the central bank aims to stimulate growth by cutting rates, it must be cautious. If interest rates are kept too low for too long, the risk of inflation rises. Increased demand from borrowing and spending can outstrip supply, leading to higher prices. If left unchecked, inflation can erode purchasing power and harm economic stability.

Impact of central bank cutting interest rates

Stimulate economic growth

When the central bank cuts interest rates, it directly stimulates economic growth by making borrowing cheaper for businesses and consumers. 

This increase in borrowing leads to more investment in infrastructure, technology, and expansion by companies, while consumers are more likely to take loans for big-ticket purchases. As businesses invest and consumers spend more, the overall economic activity rises, leading to growth.

Increase consumer spending

Lower interest rates reduce the cost of credit, which encourages consumers to borrow and spend more. 

For example, reduced rates on loans and credit cards make it cheaper for individuals to purchase goods and services. Higher consumer spending drives demand in the economy, encouraging production and job creation.

Reduce unemployment

As businesses borrow more to expand operations or invest in new projects, they often require additional workers. This leads to job creation and a reduction in unemployment. 

Additionally, with lower borrowing costs, businesses may be more inclined to hire, expand their workforce, and boost wages in response to rising demand. As more people are employed, their spending also contributes to further economic growth.

Control inflation

While central banks may lower interest rates to stimulate growth, they also need to balance this with the risk of rising inflation. If inflation is low, reducing interest rates can help prevent deflation, which can slow down economic growth. 

However, central banks need to be cautious. If rates are kept too low for too long, they risk fueling too much demand, pushing prices higher and creating inflationary pressures.

Weaken the national currency

A cut in interest rates can lead to a depreciation of the national currency. This is because lower rates make a country's assets less attractive to foreign investors, who may seek higher returns elsewhere. 

A weaker currency can make exports cheaper, boosting demand for a country's goods in international markets. However, it can also increase the cost of imports, which may lead to higher prices for consumers domestically.

Support a struggling economy

During economic downturns or recessions, central banks cut interest rates to support the economy. By making borrowing cheaper, they encourage investment and spending, which helps revive demand and stimulate economic activity.

This is especially important when low consumer and business confidence and more aggressive policy measures are needed to jump-start growth.

Can create asset bubbles if overused

While lower interest rates can drive economic growth, there is a potential downside –overuse of rate cuts can lead to asset bubbles.

With cheap credit available, investors may pour money into riskier assets like stocks or real estate, inflating prices beyond their true value. When these bubbles burst, they can lead to sharp declines in asset prices and financial instability.

Lowers mortgage and loan repayment costs

For individuals, one of the most direct impacts of lower interest rates is reduced mortgage and loan repayment costs. 

Homeowners and borrowers with adjustable-rate loans may see their monthly payments decrease as the interest charged on their loans becomes cheaper. This reduces the financial burden on consumers, freeing up more disposable income for other spending, which can further stimulate the economy.

Increases stock market activity

Lower interest rates often lead to increased activity in the financial market. With reduced yields from bonds and savings accounts, investors look for better returns in assets like stocks. 

As demand for equities rises, stock prices typically increase, which can result in a positive feedback loop of wealth creation, as higher stock prices boost investor confidence and consumer spending.

Reduces returns on savings accounts and bonds

While cutting interest rates can boost economic activity, it has the opposite effect on savers and bondholders. When rates are lowered, the returns on savings accounts, certificates of deposit (CDs), and bonds decrease. This discourages saving, as the interest earned on these assets is reduced.

Investors may shift to riskier investments in search of better returns, which can increase financial market volatility.

Encourages business investment

With lower borrowing costs, businesses are more likely to invest in expansion projects, new product development, or workforce hiring. The reduced cost of capital makes it easier for companies to take on debt and finance growth. This increased business investment can lead to more innovation, productivity gains, and overall economic prosperity. 

Additionally, lower rates may make it more attractive for businesses to take out loans to improve their infrastructure or update outdated equipment.

Navigating continual rate cuts in the economy

Central bank rate cuts can stimulate economic growth by boosting consumer spending and investment and reducing unemployment. However, if overused, they may lead to inflation, weaken the currency, and create asset bubbles. Additionally, they may reduce returns on savings and investments. Balancing growth with inflation control is essential for maintaining economic stability.