Stocks around the world this morning after the Chinese central bank announced interest rate cuts, along with lowered reserve requirements for banks to encourage banks to start lending and put a stop to the global equity selling spree.
This comes a week after the same bank drastically de-valued the Yuan, sending stocks, currencies, and futures around the world spiraling downwards. Yesterday the Dow had the biggest single-day drop in history, although it had somewhat recovered by the time trading halted.
So why cut interest rates? Central banks use interest rates and reserve requirements in their quest to constantly balance economic growth with inflation; having low interest rates makes it very cheap for people and businesses to take out loans, which can become the engine for economic growth.
Reserve requirements are what banks are required to keep in their valults and not lend out; when reserve requirements are lowered, more cash is available for banks to lend, which again can help drive growth.
However, this can come at a cost; if too many loans are taken out at the same time, it injects a lot of cash into the economy all at once, which raises prices and causes inflation. Too much inflation means that all that economic growth is lost to higher prices; instead of more economic activity, it is the same work done with bigger numbers.
These two counter-acting results mean that when the economy is strong, central banks try to raise interest rates as high as possible without hurting growth to prevent too much inflation. When the economy is weak, they lower interest rates as much as possible without causing too much inflation.
The higher the interest can get during the periods of strong growth, the more “room” the central banks have to help drive growth when the economy is weak by lowering the rates. If the interest rates are already near 0 when the economy starts to get weak, there are far fewer tools central bankers have to help get things running again.
Read more on Bloomberg