President Trump is advocating for rate cuts, a sentiment echoed by stock market investors and home buyers alike. Despite their differing motivations, they all seek to leverage these cuts as a pathway to increased wealth and prosperity.
Trump’s reasons for favoring rate cuts include a desire for more affordable credit, which would assist the Treasury in managing the staggering $37.5 trillion national debt. With the current fiscal year ending on September 30, the federal government has already amassed a budget deficit of $1.97 trillion, nearly half of which — $933 billion — is simply to cover interest payments on existing debt.
If interest rates were to decline by one or two percentage points, the annual interest burden could potentially decrease by several hundred billion dollars. While this might provide the government with extra time before facing a fiscal reckoning, it would not fundamentally alter the financial landscape.
Currently, the U.S. government is positioned to report a budget deficit of $2.2 trillion for FY 2025. Slashing interest rates may minimize this figure by only about $200 billion, making a negligible dent in the massive total of $37.5 trillion in outstanding debt.
Another motive for Trump’s push for rate cuts is the belief that lower borrowing costs can invigorate the economy. The rationale is straightforward: when borrowing becomes cheaper, business owners may be encouraged to secure loans for expansion, whether that be through purchasing new equipment, launching a new outlet, or investing in groundbreaking technologies.
Consumers also stand to benefit from lower interest rates. The cost savings on mortgages, car loans, and credit cards would effectively lower monthly payments, providing consumers with more disposable income that they could allocate towards dining out, shopping, or vacationing.
Virtuous Cycle
The surge in consumer spending drives an increase in demand for goods and services. To meet this demand, businesses must hire more employees.
The cycle operates on a basic principle: increased spending leads to heightened business earnings. As businesses earn more, they’re inclined to hire additional staff, resulting in a decrease in unemployment rates and a broadened tax base.
Moreover, lowering interest rates can provide a psychological lift. When the Federal Reserve takes action to support the economic landscape, it often instills a sense of optimism among consumers, leading to further spending and investing, thus propelling economic activity.
From a business perspective, this confidence can pave the way for new initiatives and greater risk-taking. Companies become more willing to hire and invest in research and development when they feel assured about the future trajectory of the economy.
Economists often refer to this concept as a virtuous cycle wherein lower rates lead to increased borrowing and spending, ultimately fostering job growth and greater consumer confidence. This self-propagating loop can generate a rising tide of economic success.
Additionally, lower borrowing costs mean retained cash within companies, allowing for expansion opportunities, elevated profits, increased dividends, or stock buybacks. Such actions are seen favorably by investors and can enhance a company’s stock appeal.
Anticipation
The intrinsic value of a stock is effectively the present value of its future earnings. Analysts calculate this using a discount rate to reflect the concept that a dollar tomorrow holds less value than a dollar today, with this discount rate being influenced by prevailing interest rates.
As interest rates drop, the discount rate concurrently falls, rendering future profits more valuable in today’s terms. Therefore, even if a company’s earnings remain stable, reduced interest rates can enhance the perceived value of its stock.
During periods of high interest rates, investors often find satisfactory returns in lower-risk investments such as government bonds or high-yield savings accounts. However, when interest rates fall, these safer investments offer diminished returns, making the stock market appear more attractive by comparison.
As interest rates decline, investors seeking higher returns are prone to move their capital from bonds to stocks, which escalates stock demand and drives share prices upward.
Currently, stocks are exceedingly overvalued and riskier than they were during the market peaks of August 1929 and March 2000. However, this reality does not preclude the potential for even greater risks ahead.
In anticipation of the Federal Open Market Committee (FOMC) meeting next week, investors are delving into the prospect of a forthcoming rate cut, driving stock prices upward.
This rush towards stocks, motivated by the allure of higher returns, boosts demand, creating a self-fulfilling prophecy.
With so many advantages associated with lower interest rates, one might wonder why they aren’t set to zero.
The Unvirtuous Cycle of Rate Cuts
John Locke posed a similar query over 330 years ago. In his thought-provoking 1691 essay titled “Some Considerations of the Consequences of the Lowering of Interest, and Raising the Value of Money.”
Locke intensely scrutinized interest rates during a time when the push to reduce the legal interest rate mirrored today’s efforts by the Federal Reserve to stimulate the economy.
He cautioned against such practices, asserting that interest rates are not arbitrary figures imposed by the government, but rather reflect the inherent value of money itself.
When lending money, one relinquishes the ability to utilize that capital for a designated period. Consequently, the interest charged serves as a rental fee for that temporary relinquishment.
When governments artificially depress interest rates, they distort market dynamics. By introducing excessive money and credit, central bankers inflate prices across consumer goods, real estate, stocks, and beyond.
Locke grasped that the value of money was not static, akin to a physical object’s weight, but fluctuated based on the interplay of money supply, demand, and trade productivity.
A surplus of money (high supply) paired with low demand tends to devalue currency, often leading to inflation. Conversely, scarcity elevates money’s worth.
For Locke, a nation’s true wealth wasn’t merely its monetary assets, but its productive capacity — the ability to manufacture goods, deliver services, and engage in trade. In his perspective, monetary policy should not impede this exchange mechanism; rather, it should facilitate it. Disturbing this balance through interest rate manipulations carries the risk of derailing the entire economic apparatus.
Moreover, any attempts to rectify trade disparities resulting from interest rate interference, akin to Trump’s approach with import tariffs, do not address the root issue. Instead, such measures exacerbate the underlying economic disruption, stifling the capacity for production and trade.
Locke recognized that economic forces are formidable and cannot simply be legislated away. Artificially controlling elements like interest rates without acknowledging underlying economic truths can lead to an unvirtuous cycle filled with unforeseen and often detrimental consequences. The past 112 years have positioned the dollar in a state of continual decline accompanied by soaring debt levels and deficits.
This week, gold prices surged, exceeding $3,600 per ounce in response to anticipated dollar devaluation. And there is likely more volatility on the horizon.
The orchestrators in Congress and the Federal Reserve possess a toolkit brimming with strategies for dollar depreciation. As the dollar continues to lose its value, gold prices will likely continue to rise correspondingly.
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Sincerely,
MN Gordon
for Economic Prism
Return from The Unvirtuous Cycle of Fed Rate Cuts to Economic Prism
