Rate cuts are better than negative rates

MONETARY policy has become increasingly complicated. We have rising interest rates in some parts of the world. We have falling interest rates in other parts of the world. Some central banks have taken rates negative. For investors, it is important to understand how such changes in monetary policy affect the economy at large.

Lower rates can boost economic growth in three ways. Traditionally lower rates may encourage borrowing. This is old fashioned supply and demand. If the price of borrowing goes down, the demand for borrowing goes up. The problem is that borrowing is not just about the price of credit. Borrowing also depends on confidence. Borrowers need to be confident about their future. Lenders need to be confident about the borrower's future. If there is a lack of confidence then borrowing is not likely to be encouraged by falling interest rates.

Lower rates may reduce saving. This is different from encouraging borrowing, because confidence in the future seems to play less of a role. If savers receive a lower return on their savings, their attitude may be "I might as well spend; there is no point in saving". There is an exception to this rule. If I am "saving up" - saving money to buy a car or for a holiday - then it will take longer to save the required amount if interest rates are reduced (therefore I will delay my spending).