Skip to main content

Will Lower Interest Rates Spur Economy?

March 1, 1992

Authors

Warren E. Weber Retired Economist
Martha L. Starr Research Editor/Writer
Will Lower Interest Rates Spur Economy?

The Federal Reserve cut the discount rate a full point to 3.5 percent near the end of December, and since then the cut's effect on the economy has been a hot topic. Almost from the start, the reactions of the major markets have been bold, front page news. The stock market is up. Banks have cut their rates. Even gold prices have fallen. But that isn't the whole picture. In fact, segments of the population have been hurt by these new lower rates, although the overall effect will be to spur spending and help the economy grow.

How Are You Affected?

One positive effect of the lowering of the interest rate that has received nearly universal coverage is the lowering of mortgage interest rates. These days it's nearly impossible to pick up a major newspaper or magazine and not see an article touting the advantages of refinancing existing mortgages under the new lower interest rates. And the advantages are significant. As Chart 1* illustrates, the rate on a conventional mortgage has dropped from around 10.5 percent in early 1991 to around 8.5 percent in early 1992. On a $100,000 mortgage, for example, a drop in interest rates from 10.5 percent to 8.5 percent will give a homeowner an extra $1,800 per year to spend.

Households may of course choose to save this money or use it to pay off other debts. But certainly some of it will be spent. A down payment on a car would be one way to spend it, since lower rates for car loans are also likely to be more available to consumers now. Whatever way they choose to spend it, though, the expenditure will spur the economy.

The flip side of all this good fortune for homeowners and car buyers, however, is that lower interest rates mean lower returns for financial institutions and thus lower rates of interest on savings accounts and certificates of deposit. Chart 1 shows an even steeper drop for the return rates on three-month certificates of deposit than it does for the decline in mortgage interest rates. A substantial group of the population is adversely affected by this drop.

Senior citizens, those who generally owe little and get most of their income from interest on their assets, are being hurt by the lower interest rates. This lowering of their income is likely to cause them to consume less, which may work to offset the increased consumption stimulated by the lower interest rates in other segments of the economy.

Another way to grasp the effects of lower interest rates on seniors is to compare the ratio of financial assets to debts between older families and younger families.** For example, 91 percent of older families hold assets, and the median level of those holdings is around $20,000. Nearly 83 percent of younger families hold assets too. However, the median level of their holdings is only $2,500. So if interest rates drop two percentage points, the median income loss for the old is nearly $400, while the young lose only $50.

When it comes to debts, the story is somewhat different. Only 36 percent of older families hold any debt at all, and the median level of that debt is around $4,000. Nearly 80 percent of young families have debt, though, and their median level of debt is $11,000. Since about only a third of the old hold any debt, a two percentage point drop in interest rates would give that third only $80 more to spend, while the majority of the young will have $220 more to spend.

What does this mean? It's certainly clear that the lower interest rates help borrowers (mostly the young) and hurt lenders (mostly the old). However, the real question seems to be: Does the amount borrowers are helped exceed the amount lenders are hurt? The answer has to be no because for every borrower there must be a lender. Despite the headlines and the hoopla, then, the seemingly obvious conclusion to draw is that the effects of lower interest rates on people's income add up to a zero stimulus for the overall economy.

How Is the Economy Affected?

Several forces are at work to counter this null effect, though. The increase in the stock market is one of them because this increase causes overall wealth to rise. Another is that the cost of investment borrowing falls under lower interest rates, an issue that will be addressed in a moment. Taken together, as the economic models we used will show, the net effect of these forces is to tip the balance in favor of lower interest rates stimulating overall spending and helping the economy to grow.

We used two different models to predict the effects of lower interest rates. One is the time series model developed by researchers here at the Minneapolis Fed, and the other is the forecasting model used by the Board of Governors. Both models have given us nearly identical results.

The wealth effect from the stock market increase is one of the ways lower interest rates stimulate spending. Chart 2* illustrates the rise in the stock market since the cut in the discount rate. Stock prices have increased by about 10 percent. This, in turn, translates into an approximately $550 billion increase in the stock market wealth of consumers. The Board of Governors' model, for example, estimates that each $1 increase in stock market wealth generates 3.4 cents of consumption spending in the first year. This is an $18.7 billion gain in consumption, or an increase of about 0.5 percent in the rate of growth of consumption over the year. This is a significant gain that closely matches the predictions of the Minneapolis Fed's model.

Lower interest rates also help the economy by increasing the rate of investment. This happens because the costs of financing investment, either by debt or equity, is lower when the interest rates drop. Since the costs of investing are less, companies and individuals will invest more. To understand the effects of an interest rate decline on investment, it's helpful to divide investment into three types: residential construction, producers' durables and nonresidential construction. Both the Minneapolis Fed's and the Board of Governors models can give us estimates of how large the lower interest rate effects on these investments might be.

For example, a 1 percent fall in nominal mortgage rates leads to a relatively large increase in residential housing investment. In fact, approximately an 8 percent increase in the rate of growth can be expected in the first year. A 1 percent fall in interest rates leads to a much smaller short-run impact on expenditures for producers' durables (that is, the equipment businesses might buy) than it does for housing, with approximately a 0.8 percent increase in the rate of growth expected in the first year. Unfortunately, because of the state of the commercial real estate market, lower interest rates will probably have little effect on this type of investment.

We can thus put together the effects of lower interest rates on consumption and investment and calculate the net effect on the economy. Given a 1 percent drop in interest rates and a 10 percent increase in stock prices, growth would increase about 0.7 percent in 1992 and be split just about evenly between consumption growth and investment growth, according to both the models we used.

We get this figure by taking the percentages of total gross domestic product (GDP) represented by the three main reporting areas mentioned here and multiplying by their growth rates. The resulting 0.7 percent is a fairly significant increase in the rate of growth, considering that the long-run growth rate of GDP during the 1970s and 1980s was around 2.7 percent per year.

So the answer to the question of whether lower interest rates will spur spending is yes. Taken together, the wealth effect and the increase in investment stimulated by lower interest rates should mean the Fed's policy change will stimulate spending and increase growth. Like most policy changes, however, this one will have both costs and benefits for individuals as well as benefits for the overall economy.

This article is based on a recent presentation to the Minneapolis Fed's board of directors. (Charts are not available online.)

** Here we define older families as those with heads of households over 65 years old and younger families as those with heads of households under 35 years old. (From "Changes in Family Finances from 1983 to 1989: Evidence from the Survey of Consumer Finances," by Arthur Kennickell and Janice Shack-Marquez, Federal Reserve Bulletin, Vol. 78, January 1992.)

Top