We Don’t Need ‘Normal’ Rates. We Need a New System

interest rates

Monetary policy shouldn’t solely be determined by inflation. This is according to former Reserve Bank of Australia (RBA) deputy governor, Stephen Grenville.

Grenville was a top official for 19 years. From 1996 to 2001, he saw multiple economic cycles. During his time as second in command, Grenville saw the cash rates as high as 7.5% and as low as 4.25%.

cash rate

Source: RBA

What we have today (cash rate at 1.5%) is far beyond anything ‘normal’ says Grenville.

Asset prices are bid up; risk-taking is encouraged; projects are undertaken that would not be viable with normal interest rates; balance sheet valuations are muddled; and pension plans are put in disarray.

Should Interest Rates be Increased?

It’s tough to argue that persistently cheap cash is good for an economy. All it does, as Grenville says, is bid up asset prices and skew balance sheets. But that doesn’t mean we should start lifting interest rates for the sake of it.

Central bankers do tend to emphasise inflation when talking about monetary policy. Of course it’s not the only factor at play. Central bankers also need to think about how households and businesses might respond to a change in interest rates.

For example, suppose the RBA increased the cash rate over the next five years from 1.5% to 5%. Such an aggressive increase would give commercial banks the green light to increase the cost of borrowing.

Business would invest far less than they do, as cash is no longer extremely cheap. And because businesses restrict their spending, wage growth and new jobs likely won’t grow.

Households, already up to their ears in debt, would be crushed by interest payments. The rate of mortgage delinquencies would increase far above their current levels.

What’s more, investors would flock to Aussie bonds, as higher interest rates mean the RBA will be selling government bonds, pushing down prices and pushing up yields.

This would then increase the demand for our dollar, decreasing the attractiveness of Australian goods and services to international customers.

A Chain Reaction of Damage

As you can see, lifting interest rates just because you want them to be ‘normal’ can set off a chain reaction of damage. It’s why the RBA has been so cautious when it comes to lifting interest rates in the past.

Instead of ‘normal’ interest rates, what we need is a new system. Grenville tends to agree with this line of thinking. As reported by the Australian Financial Review:

Adding his weight to growing calls around the world for a fundamental rethink of how modern economies balance monetary and fiscal policies, Dr Grenville condemned the heavy post-GFC reliance on interest rate cuts and central bank bond buying programs, suggesting they have prolonged the agony.

The economist said the problem was that weak demand meant few businesses wanted to borrow, even at low interest rates. Bank balance sheets were also in trouble after the crisis, while governments clamped down on spending to offset debt concerns – “a serious policy error that hobbled the recovery”.

Why the Current System Doesn’t Work

The reason why the current system doesn’t work is because we humans aren’t always rational. We borrow far more than we can repay, hoping that climbing asset prices will justify our investments. We also do the opposite when interest rates are high.

Monetary policy is such a blunt tool. It’s unreasonable to think it can effectively manage an economy. Surely we don’t want to endlessly swing from boom to bust?

To ignite growth, it’s up to governments to deregulate industries, foster competition and innovation and drive structural reforms. If we stop trying to force people to spend and let the invisible hand of the market do its work, I’d doubt we’d be in such a precarious position.

Cheers,

Härje Ronngard,

Junior Analyst, Markets & Money

PS: Asset prices are far higher than what we consider to be ‘normal’. This includes stock prices. Investors are buying with the hope that future economic growth and business investment will increase earnings. But what if this doesn’t happen?

A lot of stock could fall dramatically if optimistic estimations don’t become reality. Award-winning financial adviser, Vern Gowdie believes there are overvalued stocks you should definitely stay away from.

To find out if you hold one in your portfolio, click here.

Härje Ronngard

Härje Ronngard

Harje Ronngard is a Junior Analyst at Markets and Money.

With an academic background in finance and investments, Harje knows how simple, yet difficult investing can be. He has worked with a range of assets classes, from futures to equities. But he’s found his niche in equity valuation.  

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1 Comment on "We Don’t Need ‘Normal’ Rates. We Need a New System"

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Dawid
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Why would investors buy Aussie bonds if the bank is selling? Why buy today if it,s cheaper tomorrow?

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