To better understand how interest rates affect business and the economy, think about them as a virtual way of putting money into and taking money out of your wallet. When interest rates are high, the cost of mortgage payments goes higher, the cost of financing a business increases, the cost of buying anything on credit increases and investors have high-interest bonds to invest their money at low risk. When interest rates are low, mortgage payments decline, businesses can afford to expand because the cost of their capital is low, consumers are encouraged to buy on credit and investors having a hard time finding high-yield investments tend to invest in startup businesses.
Federal Reserve Monetary Policy
The Federal Reserve controls inflation by raising interest rates. This makes the cost of borrowing money expensive, thereby slowing down an overheating economy. As the economy enters recession, the Fed begins easing its monetary policy to encourage economic recovery. This is done by lowering interest rates.
Cost of Credit
Low interest rates encourage consumer spending. Consumers take advantage of low interest rates by buying houses, cars and other big-ticket items because the interest payments they will have to make on loans to buy such items will be low and their total payments more affordable. When the housing market is active, employment in the construction, manufacturing and services sectors rises, because contractors hire workers, buy building materials and appliances; landscapers and nurseries experience booming business; and new homeowners spend money on things like furniture and interior decorators. When the automobile market is active, dealerships hire more salespeople and manufacturers hire more workers and buy more steel, plastics, glass and parts.
Home construction, auto sales and purchases of consumer durables bring increased business to a multitude of lower-level suppliers, who manufacture and distribute the materials used in these products. As business increases for a company, that company generally needs to hire workers, buy supplies, update machinery and rent larger facilities. All this can be done at a lower cost during periods of low interest rates. That is why companies take advantage of low interest rates to expand their operations. When a company expands, its advertising and marketing activities also increase. This translates into more jobs for sales reps, customer service reps and advertising companies. Expanded business also increases the need for trucking, rail shipment and marine shipping, and it produces export and import activity.
When low interest rates have the effect of increasing business activity, corporate earnings rise and the stock market rallies. A stock market rally produces investment profits that increase wealth in personal investment and retirement accounts, and this increases the money supply in the country and encourages consumer spending. Low interest rates also lower the interest income on bonds, encouraging many investors to seek alternative investments that can produce a higher return. In addition to investing in common stock, many investors are drawn to investments in startup companies because of the potential they present for income and capital gains.