if the economy is doing well why does that make interest rates higher?
In: Economics
Because there is less need to make new money to drive new investment. So you slow down the creation of new money so that current money maintains its value better.
As a general rule it doesnt. Though there might be situations were the economy is doing well and interest rates need to be raised, though this is also dependend on the definition of what doing well means. Increased interest rates are mostly a result of increasing inflation.
In and of itself, economic output does not necessarily lead to higher interest rates. However, there is an important policy dimension here with respect to the Federal Reserve (and the central bank, in other countries). In effect, today’s markets are trying to guess the outcome of Federal Reserve interest rate decisions made weeks and months down the road. If the economy is doing well, the central banks are less likely to cut interest rates and more likely to keep them high.
The Federal Reserve, in turn, wants to try to balance the economy at a low rate of inflation. If the economy seems to be overheating (high inflation), it may raise interest rates in an attempt to lower inflation. If the economy is in serious trouble, it may lower interest rates to try to spur business investment and thus get the economy going again.
However, there are consequences to both decisions. Raising the interest rates doesn’t just bring inflation down; it also hurts the economy because businesses and consumers have more trouble getting loans. Lowering interest rates doesn’t just spur investment; it also raises inflation. So there are policy dilemmas: even if inflation is high, if the economy is weak, the Federal Reserve could be reluctant to raise rates to tame the inflation because that would weaken the economy even further.
For the past couple of years, we have been living with an inflation rate too high for central banks to be comfortable with (basically, anything over about 2%). They would ordinarily raise the interest rates to bring the inflation back down. So long as the economy seems to be doing okay and not suffering from the high interest rates, they will keep the interest rates in place in order to bring inflation down. If the economy does poorly, in contrast, they might be willing to live with a higher inflation for a while for the sake of saving the economy.
TLDR If the stock market thinks that the central banks are confident in the economy, then interest rates will stay higher, because there would be no reason for the central banks to cut the rates.
It doesn’t… directly. Don’t confuse interest rates (the price of borrowing money) with inflation (the change in the price of goods).
The problem is that when an economy is doing really, really well you tend to have lots of inflation (the implication is that people both REALLY want things AND have the money to buy the things they want, hence other people can charge more for them and everything gets more expensive = inflation). This is obviously bad for the people who can’t afford thing in the first place but also bad because it can all crash and burn very quickly if suddenly lots of people can’t afford things.
So inflation is something Governments and ‘people in charge’ have decided to keep a close eye upon and the *theory* is that something like a 2% annual inflation is considered ‘chef’s kiss perfect’ for a country. It implies people have money, people want things, and that people are able to get better jobs and earn more money to buy more things they want, etc. That’s the theory at least.
The problem is what happens when inflation gets WAY too high, like 10%? You go into the ‘bad’ place of people not being able to buy things anymore so the Government and ‘people in charge’ need to do whatever they can to slow things down. Pretty much the only tool they have though, are interest rates that *they* get to set. If it gets too expensive to borrow money people will slow down their purchasing and loan-getting and this will slow the economy down from the, say 10%, back to 1 or 2%.
What’s happening right now is we ARE seeing inflation coming back to the 2% range (in the US at least) but people are still generally buying stuff and borrowing money and buying things at a ‘healthy’ just slower pace. Healthy in this case means we aren’t seeing a whirlwind of companies going out of business and laying off their workers and people losing their jobs and no one being able to buy anything and everything going to shit.
It’s worth pointing out, opinions and headlines aside, this *is* what we’re seeing. Overall people are vastly keeping their jobs, companies are surviving fairly well, and people keep on buying and borrowing money. Just slower. This was their goal in *choosing* to increase the interest rate. Not everything is going to super well for everyone, some companies will have layoffs (and that’s newsworthy) but some companies will keep on hiring (that doesn’t make the news as much). So it might *seem* like we’re seeing massive layoffs but that’s more of a selective echo-chamber effect. *In General* people and companies are doing fairly well right now. Let’s be fair and say that increasing interest rates is like putting the economy on a diet, no one is going to be *happy* about it, but there is big difference being between happy, and having another Great Depression.
Keeping the interest rates high is like pinching the hose on the economy, they don’t want to squeeze the water off entirely (that would be bad) but they don’t want to release it too soon or else all the built up pressure will just come splurtting back out and ruin their work so far. They need to keep it pinched long enough so that they can be sure when they let go, they’ll keep the trickle they want, not no water and not a fire hose.
The two critical measures (and this gets complicated but in simple terms) that the Fed looks out for is inflation and unemployment. One of their tools is the interest rate. The problem is that these two measures tend to move in opposite directions.
A really fast growing economy tends (not always but usually) to reduce unemployment rate through business expansion, investment in R&D etc. However this also tends to push up inflation as businesses offer higher wages (usually the biggest single cost of running a business) and therefore increase costs to businesses. Also more wages in the economy (broadly a good thing) results in more consumption. Higher consumption can sometimes result in price increases if demand exceeds the ability to produce efficiently.
So broadly speaking lower unemployment at some point correlates with higher inflation. The reverse reasoning also holds true. Low unemployment and higher inflation correlates with a very strong (or overheated) economy which is why interest rate tends to be increased at these times.
Since interest rates take time to impact the economy, what the Fed has to do is to look ahead at many measures of economic performance and predict where they think unemployment and inflation will be in the future and modify their interest rates to mitigate any adverse outcomes. This is rather hard to do since different parts of the economy may be in different states (tech might be booming but say farming might not etc etc) so this prediction is uncertain and might impact certain areas worse than others. Interest rates tend to affect everything and isolating the impact is not feasible.
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