Interest Rate Changes: What Do They Mean?

The U.S. Federal Reserve cut its benchmark interest rate Sept 18th by 50 basis points, or 0.50% for the first time since 2020. They now have officially joined Canada in beginning to lower rates. What goes in to these decisions and what does it actually mean for the individual related to their borrowing and their investments?

Why Does The Benchmark Interest Rate Fluctuate?

First I want to make sure I cover why interest rates can go up and why they are now coming back down.

Interest rates went up in both Canada and the U.S. after inflation began rising faster than the targeted rate of 2%. This rise in inflation came shortly after the response to COVID measures, which as we all likely remember, threw a major hiccup into the global economy.

Among other measures, one of the tools used to maintain growth and thriving economies is the use of changes in the benchmark interest rate. These changes influence the cost of borrowing money for both larger institutions like banks, and then the consumer who the larger institutions pass this on to.

As I mentioned 2% is the targeted inflation rate since a small amount of inflation is healthy for economies. When economies enter into deflation or into higher inflation it creates problems for countries and individuals alike.

In this scenario where inflation rose higher, the Federal Reserve increased interest rates in an attempt to slow the economy down and lower the supply of money. If borrowing costs (interest rates) are cheap, people are more inclined to purchase things thus stimulating the economy.

They followed this path until early-mid 2024 for Canada and September for the U.S when the economic data they analyze pointed toward inflation cooling and getting back to that 2% target.

On the flip side interest rates come down when the economy has slowed, which is often coupled with a risk of recession. To try and stimulate the economy the Federal Reserve lowers interest rates in hopes of having more money supply, creating jobs and growing the economy.

In the current scenario the term soft landing has been used extensively. This means that the Federal Reserve has been trying to slow inflation through rate increases, while not putting the economy in to recession. This is a tricky objective that does look attainable, however is still not a sure thing.

The interest rates have been lowered because the economic data now suggests that inflation has cooled but the economy is struggling and slowed. This was needed to help cool inflation but now to avoid recession the Federal Reserve of both countries is lowering interest rates.

What Does This Mean For You?

In relation to borrowing it’s fairly straight forward in that interest rates will be lower. Both Canada and the U.S have further declines in interest rates expected so those borrowing rates may go down further yet. Although they are both expected to stabilize higher than the low rates during 2020 resulting from the response to COVID.

In terms of investments this is a little more complex. Lower interest rates make most fixed income investments less attractive because the interest paid to the investor is lower. In relation to that lower rates can stimulate the stock market. In principle this happens for a few reasons:

1)      People want more upside than the fixed income market is offering so they switch funds into the stock market

2)      Assuming the dividend yield of most companies stays consistent the yield from those companies may be considered more attractive than an interest-bearing investment

3)      The individual companies also have access to lower interest rates which can help promote faster growth and can increase their bottom line making them more attractive to invest in

One more thing to note is the impact on a country’s currency. Generally, when interest rates are lowered we see a drop in value of the currency as compared to other countries.

For example as Canada was lowering interest rates and the U.S was not, the Canadian dollar relative to the U.S. dollar went down. Once the U.S. was expected to begin cutting it’s benchmark rate the value of Canadian dollars to U.S dollars went up.

Of course, nothing is guaranteed and it’s always a waiting game with hindsight being 20/20.

We are now back into a bull market and with interest rates coming down, company earnings still strong, and inflation cooling, there is reason to be optimistic in both the markets of Canada and the U.S.