What role do interest rates play in macroeconomic cycles?

Interest rates play a key role in the economic cycle, where they are used as a tool to moderate the performance of the economy. At low growth rates, interest rates are decreased to allow the economy to expand. While at high growth rates, interest rates are increased to contain inflation. But interest rates have wider effects as their changes signal the direction of the economy. Raising interest rates by central banks signal an overheated economy and a future slowdown, leading to drop in stock prices. Also, interest rates affect the debt servicing cost of companies, where highly leveraged companies get into financial difficulties. The same applies to countries which are heavily in debt and get to face an expanding debt service burden.

I don’t agree that interest rates are tools to moderate or accelerate economic growth. I think that increase/ reduction in liquidity in the system is more important. Markets can absorb higher interest rates if liquidity is ample for example in the current cycle Fed has done one of the fastest rate hiking cycle in the history but economic growth is not moderating. Interest rate hike might moderate economic growth through consumer spending but continuous fiscal spending is making mockery of rising interest rates.

Level of interest rates play a key role in determining the inflation level and the momentum of growth in the economy. Central Banks like the Fed with a dual mandate (stable prices and full employment) tend to vary interest rate as per the inflationary environment. Higher interest rate regime hurt the business sentiment as borrowings become costly and Households reliant on debt delay their purchases thus leading to lower consumption. The doom loop ends with a slowdown and a recession which removes the excesses from the economy. As unemployment rate rises and inflation falls due to demand contraction, central bank lowers the interest rate to stimulate the economy. In this way, we get our typical business cycle.

Interest rates is one of the anchors that determines which way the economic cycle will take. When an economy is at full employment and overheating from burgeoning demand, it makes sense to attract investment to meet such demand, but when that is unobtainable, elevated interest rate could come to the rescue. Also, it is the case that it could as well be a means to steering an economy towards full employment in a period of dwindling aggregate demand as monetary policy authorities drops interest rate. However, it must be said that the tool has not been as effective as it as proven in advanced markets in some emerging and frontier markets. The transmission mechanisms are not just there.

The ecosystem of the monetary policy framework consists of Bank Reserves, the Treasury General Account (TGA), and the Reverse Repo Program (RRP). The interplay between these variables determines the amount of liquidity in the system. Simplistically, interest rates, in conjunction with the availability of liquidity, determine the cost of money. An increase in the Fed funds rate makes it more expensive for consumers and corporations to borrow across the board, and it begins to slow down economic growth as disposable incomes get squeezed. We are currently in an environment where interest rates have risen over 500bps in just over a year, which, when coupled with QT, is likely to have adverse ramifications for the global economy.

Interest rates and inflation go hand in hand. To control inflation, central banks around the world use the most powerful tool in their hand-Interest rates. Increasing interest rates is said to control inflation. However Inflation is not always related to money supply. If there are supply side factors then inflation tends to be stubborn and increasing interest rates has very little impact on cooling inflation. Exactly the same phenomena is playing currently. Hence most central banks are indicating higher interest rates for longer period of time. But like all other indicators interest rates too move in cycles and when central banks see sustained fall in inflation they would start cutting interest rates.

I tend to agree that interest rates have started to play a decreasing role in accelerating or moderating economic growth. But the impact differs from country to country. In some economies, it has no impact whereas in others it has limited effect.

Economic Cycle - 4 phases: Expansion: The economy is good. People and businesses borrow money easily, and demand for goods and services goes up. It's a "boom" time. Peak: The economy is at its best, but sometimes, it's too much. Inflation starts, and interest rates might go up to cool things down. Contraction: Things slow down. Businesses make less money, and people spend less. This can lead to a recession. The government may use strategies like lowering interest rates to boost the economy. Recovery: The economy hits its low point and starts growing again. Businesses expand, jobs are created, and the economy gets better. These phases keep repeating.

One may appreciate the elasticity of Inflation and Interest rates in a vibrant economy. It is not always the reflection curve of Demand and Production challenges. It will be a wise analysis to seek ways to detach Cash Flow challenges from need to ask for reduction in interest rates. Covid shake up demonstrated that supply chain issues made inflation so pertinent. Now to bring interest rates to optimum , market need to harvest on demand side to reign in Inflation.

A note needs to be added that this relationship assumes generally low inflation. If inflation is high enough (e.g., like in USA in 1970s or in modern Türkiye or Argentina), the classical cycles break and the output trough may coincide with the peak in the inflation and interest rates.

The ultimate effectiveness of using lower interest rates to facilitate more broad economic growth, or using higher interest rates to contain core inflation is still subject to MUCH debate, from economists, economic policy makers and the big economic schools of thoughts. On the latter, you can find Nicholas Wapshott who wrote Keynes Hayek: The Clash that defined Modern Economics in 2011 on LinkedIn. It's worth a read!

During stage like expansion when economy is picking up the growth,implying more consumer demand of product & service making industry sense this business opportunity to push the supply. In order to produce more product,the industry needs more production capabilities and hence requires monetary support implying demand for money. The lending institutions sees this opportunity and jump in with aggressive loan schemes with reduced interest rates (actually its central bank which reduced the repo rate first supplying cheaper money to banks) Hence we can say, during macroeconomics stage like expansion, role of int rate is to enable the businesses to contribute to the required supply to meet the consumer demand by providing them money at lower cost.

Based on the observed economic history, this relationship between exchange and interest rates works however only within a reasobly low interest rate range (between 0% and perhaps 6%). Currencies that most of the time have a higher rate (e.g., Mexican Peso, Russian Ruble or South African Rand) tend also to have higher inflation and slide against USD over years.

In my view, interest rates not only shape economies but also influence investments. Post-2008, reduced rates spurred spending and drew foreign investors due to affordable financing and competitive exports. Furthermore, these rates play a key role in the ebbs and flows of the macroeconomic cycle, dictating periods of growth or recession. This underlines the importance of rates in both economic trends and investment decisions.

Interest rates impact the macroeconomic cycle: Higher rates discourage spending, promote saving and investing, reducing demand and output. Lower rates stimulate spending, discourage saving and investing, boosting demand and output. However, interest rates must work together with fiscal policy to manage the economy effectively. Currently, many central banks are raising interest rates to combat high inflation, while many governments are increasing spending to support the economy. This combination of policies is unusual and there is a risk that the two policies could work against each other.

Interest rates can indirectly impact technical analysis by influencing investor behavior. For example, rising Interest rates may lead to higher borrowing costs and affect investment decisions, which can be reflected in market trends and patterns observed through technical analysis. In this way, interest rates serve as a fundamental factor that can influence the context within which technical analysis is conducted.

It is important to correctly determine the time horizon of the signal to trade on it. A mistake that many traders in my observation make is they apply an economic cycle theory - which describes processes that take years to unfold - to enter trades with much shorter time horizon.

Interest rates impact macroeconomic cycles significantly. They're low during expansion, rise at the peak, and high in contraction. Low rates encourage investment and spending, while high rates curb inflation. They affect investment, consumption, housing, exchange rates, savings, and inflation. Central banks use interest rates to balance economic growth and stability, making them crucial for overall prosperity.

Though this article covers the cycle within a country, it does not cover the effect interest rates have on other countries and the fx-rate. That is the global consideration should be considered. In an interconnected global economy, the interest rate policy of one major economy can impact others. For instance, if the U.S. Federal Reserve raises interest rates while other major economies maintain or cut theirs, it could lead to increased foreign capital inflows into the U.S., strengthening the U.S. dollar but potentially leading to vulnerabilities in emerging markets or other countries.

A decade+ of zero/ negative interest rates has led to buildup of huge amounts of debt and financial stability risks. This is something to consider when using interest rate as a tool going forward.