Why Does the Fed Lower Interest Rates? And What’s the Economic Impact?

This Wednesday, the Federal Reserve Bank revealed that it would keep interest rates near zero until the year 2023. The statement is a sign that the Fed anticipates a long, slow recovery from the coronavirus recession.  Interest rates, as set by the nation’s central bank, have been near zero since March, when the pandemic first disrupted everyday life in the United States.

So why does the Fed lower interest rates when the economy is slowing? Let’s take a look.

Why lower interest rates?

The goal of the Fed is to keep the United States economy afloat in two key ways:

  1. Minimizing unemployment
  2. Stabilizing inflation

The Fed accomplishes this by increasing or decreasing interest rates. When the economy is weak, or when the Fed sees signs of an economic slowdown, it will lower interest rates. This makes it cheaper for individuals and businesses to borrow money. Since businesses can borrow money at a lower cost, they are able to keep their employees on the payroll, and hire more staff.

Lowered interest rates also make it less profitable to keep money sitting in a bank account, since those savings will accrue less interest. As a result, the Fed’s low interest rates encourage people to take their money out of the bank, and spend it, which stimulates the economy. It also encourages business to barrow to expand.

In a time when job security is uncertain, people might feel disinclined to spend their cash. But by encouraging people to spend, the Fed can keep money circulating and the economy running.

Lowering interest rates can also have an effect on the stock market. News of falling interest rates can cause markets to rally, as they did in June of last year, after Fed Chair Jerome Powell hinted that interest rates could fall in the coming year. That happens because as rates go lower, people can make more money by owning stock, rather than by leaving it in a savings account.

So when does the Fed raise interest rates?

In the end, the point of lowering interest rates is to push people to spend money. During a time of low interest rates, your savings can actually lose value by sitting in a bank account. And that’s the reason why, as an economy recovers, the Fed will eventually raise interest rates. In a recovered, healthy economy, the goal is to avoid overheating, a time when there is inflation. At that time the Fed’s goal is encourage people to start saving money again. That gives banks the financial cushion to use when the economy declines in the future.

When the economy is in decline, the Fed wants to stimulate activity, so it lowers interest rates. In contrast, when the economy is healthy, the Fed wants to keep a lid on activity to avoid inflation, so it raises interest rates.