falling interest rate – LUCKY IDIOT

Generally, the economy works as either a free economy or a communist economy. But the most accepted free economy also needs government interference sometimes. There are interventions made by controlling authorities for shaping the economy and help the economy to grow well.

Central Bank

Central Bank such as RBI concerns managing the economic cycle which is mainly through inflation and employment. Inflation has a two type –

Demand-pull where the demand for products increases more than of supply.
Cost-push where prices of labor and raw materials increases.

Central Bank involves in reducing money supply in the economy through increased interest rates, selling of securities which resulted in lower demand due to lower availability of money and inflation comes down.

Such an act also hampers the growth of an economy.

When it comes to generating more employment in the economy then the central bank increases the money supply to the economy through reducing interest rates, purchases of securities (quantitative easing), etc.

Central Bank has to maintain a balance between employment generation and limiting inflation.

INTEREST RATE CUTS: DOES IT PROVIDE LONG-TERM BENEFITS?

Government

The government has a wide area of responsibilities and the economy is one of those. The government has the main tool for managing the economic cycle is fiscal which includes taxing and spending. So, for stimulating the economy, government cuts tax, increases government spending, provides stimulus packages. Government reversely increase taxes, reduce spending and another stimulus when they feel that the economy is overheating.

Also, the government has to look after the deficit which results in the increases in debt levels.

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The above stimulus will invite higher taxes when either economy overheating or debt level of economy crossing limits.

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If higher taxes and lower spending by the government with the fiscal surplus resulted in the lower down of debt level and the fund goes out of the economy. Reversely, lower taxes and higher spending by the government bring more fiscal deficits and that will have resulted in the increasing borrowing levels.

Similarly, currently, Government has cut corporate tax rates in India and this will have resulted in the above process mentioned in rate cut but in a longer period, this lower tax can be increasing a debt level. India is a developing economy that requires higher government spending as well so that that will surely going to increases a deficit and will increase a debt level. But for stimulating growth in the economy it is a welcome step. Otherwise, the economy starts failing. The government has to take appropriate steps whenever requires.

Disclosure – Companies mentioned in the article are just for an example & educational purpose. It is not a buy/sell/ hold recommendation.

Read for more detail: Mastering The Market Cycle: Getting the odds on your side by Mr.Howard Marks

When rate cuts happen, people think that the economy is weak so that it required a rate cut. The reduced rate provides stimulus to the economy which resulted in the stronger GDP, higher corporate profits and higher stock prices. This is the first-level thinking.

Rather second-level thinker thinks that –

Why do rate cuts happen?
The economy is weak or weakening?
What damage can occur if rate cuts not happen?
How much worse it is?
Does this rate cut help to revive things?
Shouldn’t we need to take rate cut as a worrisome scenario?

A very nice example quoted by Mr. Marks that when we visit a doctor for our weak health and then he works on healing us through higher treatment, should not this worrisome for us?

First level thinker takes it as this treatment heal us and we will get all right soon

Whereas second-level thinker take it as –

how much worse it is that such high treatment is required? Or the situation is worsening highly?
Does it resolve the issue?
Is this treatment sufficient?

We need to think that the doctor has to bring a higher treatment that means simple treatment does not go to work for healing us. This means either issue is big enough or it is on the way to becoming bigger. So that when we have a bypass that means chest pain is not because of a gas problem but actually, we have a heart attack.

What can lead to growth at a lower interest rate?

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Lower cost of borrowing – lower interest on EMI – more savings leads to more spending on the consumer front and that resulted in the GDP growth
Lower cost of borrowing – encourage businesses to make an investment – lower cost leads to more cash left with businesses to make further Capex – earning starts growing – more dividends or stock buyback enhance cash inflow to the investors – more spending – that increases GDP
Consumer spending increases – demand increases – encourage businesses to invest – more employment opportunities – more wages – increase consumers spending – GDP increases

The most important thing is that when interest rates go down then we reduce discount rates also. So that lower discount rates resulted in the higher assets prices. And lower rates encourage investors to take more risk to earn more return in the low return world.

Rate cuts provide hints for future rate cuts. And the above cycle keeps repeating.

There are many situations where lower rates are undesirable –

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Low rates increase the inflation (some inflation is required for the growth but excessive can kill) – too much inflation increases cost of living – it makes hard for people to spend more money – lower rates reduces the return on the cash, money market investments, high-grade bonds so that people make an investment into the risky products to earn more return – people take more leverage to make an investment – this creates an assets bubble & some point of time it will burst.

Due to the lower interest rates, we provide lower discount rates to the assets which have increased the price of the assets and when the bubble burst interest rate increases which creates huge damage to the prices of the assets.

This is like painkillers which cure pain for now but harmful to health over a longer period if we continue with taking painkillers frequently for immediate relief then it can destroy our health in the future. So, we need to be careful while taking a painkiller for curing pain at the time.

We need to focus that whether growth is natural or artificial stimulating growth. If growth is not natural then central bank and government have to take measures to boost growth. Such kind of growth does not survive for long without stimulation.

As current slowdown is not only cured through rate cuts but the government need to bring further measures which can provide long-term domestic growth without any temporary stimulation. Temporary stimulation brings future demand in the current period or till the stimulation remains in the force. After that demand starts getting dry up. Such a stimulus can be more harmful and lead to huge damage to the economy at whole.

Inspired from Howard Marks memo – “On the other hand”