What happens when interest rates go down?

When interest rates fall

If you’re investing or borrowing money, the interest rate (the amount of interest due per period) is important.

Depending on the state of a country’s economy, interest rates may be rising or falling at a given point in time.

Let’s see how interest rates are determined and the advantages and disadvantages to falling interest rates.

The neutral rate of interest and inflation

The neutral rate of interest is the rate at which the Bank of Canada monetary policy isn’t stimulating nor holding back the economy. It allows the economy to continue growing, without inflation getting out of hand.  

Institutions that create monetary policy (such as the Bank of Canada) and economic researchers aim to estimate the neutral rate of interest. In April 2024, the Bank of Canada estimated the Canadian neutral rate of interest to be between 2.25% to 3.25%.  

Since 1991, the Bank of Canada has also used an inflation target of 2% in setting their monetary policy. They use this number because inflation tends to be close to 2% when Canada’s economy is running near its capacity or when demand for goods and services is roughly equal to what the economy supplies.

The interest rate can impact the inflation rate.

If the economy is running below capacity and inflation is falling below target, the Bank of Canada may lower the interest rate, leading to:

1. Interest rates for mortgages and car loans tend to fall.
2. Since it’s cheaper for households and companies to borrow money, they feel encouraged to spend and invest. As a result, demand in the economy may go up since it’s more cost effective for people and businesses to borrow money.
3. The higher demand could brings the economy closer to its capacity, helpings inflation move closer to target.

If demand is too strong and pushes the economy above its capacity, the Bank of Canada might raise the interest rate to stop inflation from rising above target. This could lead to:

1. Other interest rates rising.
2. Borrowing would likely become more expensive and demand in the economy  could decline.
3. Lower demand bringing the economy back down toward capacity and pulling inflation down closer to target.

Advantages of a falling interest rate

Less expensive borrowing

• Lower mortgage interest rates could save homeowners thousands of dollars over the term of their mortgage.
• Personal loans and lines of credit will be less expensive which could mean you’ll be able to pay down debt faster.
• You may also be able to refinance a mortgage or pay off a loan with a home equity line of credit.
• First-time home buyers may be able to qualify for a mortgage easier.  

Consumer spending increases

• Because the inflation rate and economy is more predictable, consumer confidence could increase, motivating people to spend on items such as cars, homes, appliances, etc., rather than save.

Economic growth

• Increased consumer demand means retail and manufacturing businesses have greater confidence to expand and hire more employees.

Stock market gains

• Because companies are facing lower costs and rising demand, their profits and stock prices could increase.
• Investors may choose to move their assets from fixed return investments to stocks.

Disadvantages of a falling interest rate

Increased debt

• Lower interest rates can encourage people to borrow more, whether it’s for real estate or household purchases. Should interest rates rise again, then it could be difficult to manage that debt.

Lower return on savings

• The interest rate for fixed rate investments such as guaranteed investment certificates (GICs) and savings accounts could decrease
• At some point the return on these types of investments may not keep up with inflation forcing risk-averse investors to choose investments with more risk.

Demand inflation

• Increased consumer demand may mean the prices of some goods increase unless the supply of good also increases.

How lower interest rates can impact the economy

Weaker Canadian dollar

• When the interest rate falls, the value of the Canadian dollar may also fall. This makes our exports cheaper abroad. However, it also makes imported goods more expensive which can increase the cost of living.  ​
• Depending on currency exchange rates, travel to some countries may become more expensive.

Lower unemployment

• When companies decide to expand and hire more workers, it can lower the unemployment rate.

Increased government borrowing and spending

• Because it costs less for governments to service the debt on their loans, they may be tempted to borrow more to fund infrastructure, social programs, etc.