if the economy is doing well why does that make interest rates higher?
In: Economics
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.
Latest Answers