Why wouldn't higher interest rates somewhat stimulate the economy?
I have a question regarding the idea that higher interest rates result in economy contracting, which I can definitely see since low interest rates = low cost of capital. However, my macroeconomics professor in college taught that higher rates were necessary to incentivize consumers and businesses to save, which was required for investment - countries will low savings rate struggle to develop. I'm having a hard time reconciling the two concepts, since they seem to contradict - to what extent are higher interest rates necessary to saving, thus investment growth?
Bump
Higher interest rates create uncertainty around market returns, so people turn to savings and interest for guaranteed returns. Higher savings does boost investment, but over the long term.
Looking at an individual, it’s not logical that they increase their savings rate and investment rate at the same time. But, after a period of increased saving they will have excess capital to deploy across selected investments when confidence in the market returns.
So at the onset of higher rates, there would be temporary boost in savings which would spur investment for a short while?
Look at it this way - We’re coming from a period where we had gotten used to low rates, leverage was cheap relative to what it is now. Projects could be funded at >8-9x EBITDA and little needed to be put upfront as equity since liquidity was both cheap and readily available for financing growth since banks/credit investors could either sit on cash or deploy it in a red hot market. Corporates could support higher leverage levels on floating rate debt since interest payments weren’t painful enough as they’ve gotten now as both benchmark rates and spreads have gone up with terms on credit getting tighter.
Any household with surplus cash doesn’t want to pursue high risk investment options (stocks and highly leveraged fixed income instruments) since they could just put their money in 10yr Treasuries or other risk-off options for decent returns.
Neoclassical economics however tells us that an individual wants to maximise their lifetime utility function (a.k.a opportunity cost of consumption in high rate periods is high and hence saving is preferred which then leads to higher investment levels in subsequent periods spurring growth). This is in line with what you may see in markets now (move to risk-off govt bonds) and rotation to risk-on securities or investments once policy rates come down and risk-off investments becomes less attractive over time.
Lower rates are good for incentivizing investment. Higher real rates do incentivize savings which increases deposits which should lower rates which then incentivizes investment. That's partially why we call it a business cycle. However, it doesn't all happen at once.
Also, the Fed intervenes before this process is allowed to play out.
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