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?
- 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 –
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”