Friday, 9 April 2010

KRIS SAYCE: Why Interest Rates Aren’t What They Used to Be

_Kris_Sayce_headshot Kris Sayce from Money Morning Australia serves up a lesson on interest rates that is far too simple for any of the mainstream commentators to understand.

UK Prime Minister Gordon Brown has called a general election. Unless we’re mistaken, it’ll be the first-post stimulus election for an incumbent leader of a major economy – Obama’s election doesn’t count as Dubbya was prevented from contesting a third election.

As for the UK election. We’re not sure it matters who wins, whether it’s Labour, the Tories, or a hung parliament. As far as we can see, it’ll be the same muck just a different spreader.

And finally, before we get on to today’s Money Morning, we did have a little chuckle at the misprint in today’s online edition of The Age. It seems that even in retirement, Malcolm Turnbull is having trouble getting his global warming message across:
Malcolm Turnbull having trouble getting his global warming message across
The Age later corrected their mistake to read “Threat of global warming remains.” Bless!
Then again, we’ve long suspected the global warming fear campaign is seen as a treat for those in the public service that get to spend all the expropriated tax dollars.

But today we’ll take a look at interest rates. Before we do, one thing struck us as we flicked through the Australian Financial Review (AFR) this morning.

It was the table illustrating the effect of the “Loan hikes.” In English it means how much your monthly mortgage payments will increase thanks to the Reserve Bank of Australia’s (RBA) 0.25% rate rise.

The thing that struck us was the loan examples used. We’re sure it wasn’t so long ago they used numbers such as $100,000, $200,000, $300,000 and $500,000.

Not anymore. Today it’s $250,000 as a minimum. Followed by $500,000, $750,000 and to top it off a whopping $1 million.

But who knows, maybe it’s been like that for some time and we’ve never noticed. But then again it’s hardly surprising when the median home price in Sydney is over $600,000.

Anyway, back to interest rates.

Quite frankly, the new attitude towards interest rates is perhaps the most troubling of all the issues facing the Australian and international economies.

This quote from an article in today’s Sydney Morning Herald (SMH) pretty much sums it up:
“The marketplace is driven by supply and demand. It’s not driven by interest rates.”
That’s according to Wayne Stewart of the Real Estate Institute of New South Wales. Naturally he doesn’t stop there:
“The greatest problem that we’re facing is the shortage of property. It’s an absolute crisis.”
Heard that one before. We think Urban Taskforce Australia chief executive Aaron Gadiel agrees. He says:
“Each interest rate rise is tantamount to a game of Russian roulette with Australia’s housing supply…”
More like a game of Russian roulette with the first home buyers who were bribed into the housing market on the back of record high property prices and record cheap money. Except in this bizarre game it’s the RBA and government aiming the gun at the heads of first home buyers rather than the buyers doing it themselves – load, aim, fire!

But here’s the main problem with interest rates. And it’s got nothing directly to do with the housing market.
The real problem is the attitude of market participants towards interest rates. It’s summed up perfectly by Mr. Stewart’s comment above. In a nutshell, what he’s saying is that interest rates aren’t that important. Of course, he does say in the same article that “There are people where any increase puts them on the breadline.”

But that plays second fiddle to the furphy about a housing shortage.

It’s the old story about central banks artificially manipulating the economy by fiddling around with interest rates.

But let’s get back to basics. What’s so important about interest rates? The obvious answer is that interest rates represent the price of money. A low interest rate means money is cheap. A high interest rate means money is expensive.

A low interest rate means that saving is discouraged as the returns are low, therefore individuals will look for higher returns elsewhere or they will spend.

A high interest rate means that saving is encouraged as the returns are high. Therefore individuals may not
invest elsewhere, and they’ll be less inclined to spend.

That’s all fairly straightforward. But aside from that, interest rates have another function other than just how cheap or expensive money is. Interest rates provide the market with a signal.

As Mr. Stewart above mentions, “The marketplace is driven by supply and demand.” He’s right. In this case interest rates are the supply and demand indicator for money. You can’t ignore this.

Yet, the manipulation of the interest rate and the misunderstanding of interest rates across the mainstream has turned the interest rate indicator upside down.

Whichever way interest rates move it’s seen by the mainstream commentators and analysts as being a positive sign for the entire economy. Or that there’s only one response to both high and low interest rates – spend money NOW!

That’s not the way it should be.

If you can imagine a world without the meddling of megalomaniacal central bankers, the setting of interest rates would be determined by all market participants. Sounds weird doesn’t it? That a market could determine a price level without the interference of a public service mandarin.

But interest rates are no different to how anything else is priced. In most cases in an economy prices are determined by the free market. A can of Coke Zero at the milk bar across the road from here costs $2.40 or $2.50 (depending on whether we’re served by the husband or the wife apparently!)

Yet up the road, a Coke Zero only costs $1.30 at the local IGA.

As far as we’re aware, there isn’t a Coke Zero Tsar employed by the government to set the price of Coke Zero across the country. As strange as it seems, the market is able to set prices for itself. Some prices for similar goods are cheaper than others.

While we’re on the subject, isn’t it amazing how the free market makes goods available without a command from the government? We’re not forced to buy Coke Zero, yet we choose to. The milk bar or supermarket takes a risk on there being a demand for Coke Zero and therefore stocks it in anticipation.

It doesn’t need the government to legislate the supply of Coke Zero or any other consumer product. The free market determines it. Yet when governments get involved, suddenly the market doesn’t function properly – look at the former Soviet Union or Cuba as a perfect example.

Anyway, some days we can’t be bothered making a 10 minute roundtrip walk to the IGA so we make the two minute roundtrip walk to the milkbar instead. The extra $1.10 (or $1.20) that we spend is the cost of the convenience of drinking the Coke Zero 8 minutes sooner than if we’d gone to the IGA.

That’s how markets work. Why should the cost of money be any different? Of course, in some respects it isn’t. Different banks may charge a slightly different rate for a mortgage or a business loan, but the fact remains that the basis for their lending rates is determined by the rate set by the RBA.

Now, you could argue that the rate the IGA or milkbar charges for a can of Coke Zero is determined by the wholesale rate charged by Coca Cola, but the difference is that Coca Cola doesn’t have a monopoly on soft drinks in Australia whereas the RBA does have a monopoly on interest rates in Australia.

Anyway, sorry for the digression. In a free market, the function of the rate of interest is to provide a signal to market participants (you, me and the other 22 million people) that would let them know whether they should be saving or spending.

If businesses wanted to invest in capital goods for instance, they would seek a loan from a bank. If the bank didn’t have enough reserves to lend then it would need to attract more deposits. It would do this by increasing interest rates.

This would encourage individuals to save rather than spend. Or it would encourage them to save in a bank rather than take bigger investing risks elsewhere, such as in the stock market. For the business that needed to borrow to invest in capital goods it could mean that the rate of interest it’ll pay is higher than anticipated and therefore the business owner would need to decide if the higher cost of money still makes the investment in capital worthwhile.

If there is a lower demand from businesses to borrow money then banks would lower the rate of interest they pay savers as the bank doesn’t need to attract more deposits. It wouldn’t want to pay 5% to savers when it was only receiving 3% from borrowers.

In this instance saving is discouraged and instead individuals choose to spend their money now rather than in the future.

And that’s what interest rates should be. But right now that’s not the function given to interest rates.
Instead, the mainstream economists and commentators have turned interest rates into a sideshow. A sideshow as pointless to the functioning of the market as Punxatawny Phil is to the weather forecast – “The RBA hasn’t seen its own shadow, interest rates will go up and the economy is booming. Spend and borrow now before it’s too late!”

So now, rather than interest rate rises being seen as an indicator for individuals to stop spending and to save, the mainstream commentary tells the masses that rising interest rates is proof the economy is strong and therefore you should carry on as you were – spend and borrow.

The sad point is, that due to the manipulation of interest rates and government propaganda, individuals are never given a break from the same message. The message is always to spend and borrow, regardless of where the interest rate is.

When interest rates were forced lower the message was that individuals must spend, spend, spend to prevent the economy from dying.

In a free market where interest rates aren’t manipulated, it would be a fair argument to say that individuals could spend when interest rates are low. Because in a free market the interest rate would have moved lower due to a lack of demand for borrowing.

But that wasn’t the case. Interest rates were forced lower by the RBA, but borrowing continued full steam. Lower interest rates should have indicated a lower demand for borrowing. When borrowing continued to surge interest rates in a free market would have moved higher, but they didn’t.

Only now is the RBA again manipulating rates, this time by moving them higher. But still the message is the same – borrow and spend.

As we’ve pointed out several times, it was a myth that Australians were deleveraging. They did no such thing.
Stats from the RBA show that borrowing for housing in particular has continued to soar. And it continued to soar because interest rates were held artificially low by the RBA. It’s why you had the instance of banks offering savings rates well above the cash rate, as the banks tried to encourage more depositors.

That’s pretty tough to do when everyone is borrowing at record low levels, encouraged by the idea that it’s a perfect time to borrow.

In a nutshell, interest rates aren’t what they used to be. The fact is, interest rates are little more than just another economic indicator. They’ve been manipulated beyond all recognition.

It’s no longer possible for you to use interest rates as a gauge of whether you should spend or save. No more than it’s possible for you to base your saving or spending decisions on whether the NAB Business Confidence survey shows a positive or a negative figure, or any one of the other sideshow indicators.

The message from the RBA – regardless of what the Governor tells Kochie, mainstream commentators and mainstream analysts is that you should spend and borrow whatever the rate of interest, because that’s the only way to ensure the Australian economy never dies.

So, in a way, Mr. Stewart from the REINSW is right when he says the market is, “not driven by interest rates.” It isn’t, but it should be. And for that you can ‘thank’ the RBA and the mainstream commentators.

It’s a very sad state of affairs indeed.


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