How Low can the Interest Rate Limbo Stick Go?

They all agree. The Treasury secretary Martin Parkinson, APRA’s Chairman Wayne Byres, analysts at Credit Suisse and Moody’s, and even ASIC. They all agree low interest rates raise the risk of too much debt. They even told Australian Financial Review journalists, as you can see all over today’s rag:

‘Australia’s top Treasury and regulatory chiefs are concerned record low interest rates could destabilise the financial sector amid predictions many homeowners will struggle to service their share of the nation’s $1.4 trillion in mortgages when interest rates start to rise.

‘Treasury secretary Martin Parkinson indicated the global monetary ¬policy stimulus, which has driven mortgage rates below 5 per cent for the first time, was raising the risk of a repeat of the 2008 crisis.’

So stop lowering interest rates? Bahahaha, you must be kidding!

The debate over how low rates should go rages in the blogosphere. And probably at the Reserve Banks’ boardroom in Martin Place. Inflation is high, but so is the currency. Growth and jobs are iffy. And so on…

Yes, interest rates aren’t the most interesting of topics (pun intended). But we’ve already spent too much time puttin’ Putin’s critics in their place. And tomorrow’s far too personal edition of The Markets and Money only briefly goes on to introduce you to the financial industry’s replacement. So today it’s financial market matters only.

If you’re not convinced a discussion of interest rates matter to your daily propaganda intake, you’re missing the most important part of any financial crisis’ story. America’s housing bubble burst when higher interest rates struck. They smacked retired Federal Reserve Chairman Alan Greenspan in the back of the head like an American tourist throwing a boomerang and then forgetting about it.

In the same way that Australians could see the boomerang coming, Austrians saw the housing bubble’s pop coming. People who believe in the Austrian School of Economics, that is. They’ve long understood how interest rate manipulation leads to the boom/bust cycle. But it’s the fact that the mainstream is coming on board with the Austrian version of events that is so interesting. They’ve figured out part of the narrative of what makes financial crises happen. But how?

Of course, interest rates determine how much money those on the bottom rung of Australia’s greasy housing rope-ladder have to live off. But let’s focus on the amount they borrow in the first place. Interest rates are the price of debt. Lower the price and people borrow more. Which in turn bids up the prices of what you buy with debt (houses). Higher house prices mean more debt. Which is unaffordable, unless you lower interest rates. Which spurs more borrowing… Rinse, lather, repeat.

All this leaves nobody, except the bank’s financial statements, better off. Everyone else has more and more debt.

But the price of debt can go back up too. And that’s what the previously mentioned institutions have just figured out. The Sydney Morning Herald quoted Credit Suisse’s Damien Boey and Hasan Tevfik:

‘“It would only take 100bps [1 percentage point] of rate hikes to bring the debt-servicing ratio back to GFC highs, which we view as unsustainable.”’

That’s their take on the Reserve Bank of Australia and the interest rate outlook and part of the reason why they think if the RBA did raise, the peak would be below 3.5 per cent. Right now rates are at 2.5 per cent.

So Australia’s regulatory and analytical institutions are worried about what will happen when rates do rise. Anyone who paid attention to America’s housing market knows what will happen. And it won’t take much of an increase to trigger those problems.

There’s no sense dwelling on what the mainstream has finally figured out. You’ve picked your side by now. You think Australia does or doesn’t have a housing bubble. Either you own property investments in Australia or not. (As always, it’s worth mentioning there are non-financial benefits to owning a home that can outweigh the financial.)

But there’s a different point that we think hasn’t been figured out yet — the fact that all this is the Kiwis’ fault. They’re the ones who have led the world into thinking fiddling with interest rates is a good idea, regardless of the debt bubbles it creates.

The Board Blacks, as the Reserve Bank of NZ board will now be known, were the first to implement inflation targeting. It’s as recent (and therefore unproven) an idea as 1990.

Then again, you might say it’s been disproven by the constant bubbles since 1990. The tech bubble, the sub-prime bubble and now the China/sovereign debt/bond/social media and everything else bubble.

If a central bank targets inflation at the expense of other indicators, as it’s directed to do by law in most countries, why would it worry about asset bubbles and the like? Are they even allowed to worry about them legally?

The price we pay for price stability, if you can call 2% inflation ‘price stability’, is asset bubbles. They’re an inherent part of not allowing prices to fluctuate and fall naturally as the economy becomes more productive. Inflating a balloon 2% a year still makes it pop.

Ironically, New Zealand is leading the interest rate raising charge. Just this week, the Kiwi central bank raised its interest rate for the fourth time since March. The rate is now 3.25%. Perhaps the Kiwis are looking to redeem themselves by trying to prove you can raise rates without popping debt bubbles. They certainly have their own housing bubble.

Now that authorities have figured out interest rate manipulation risks debt bubbles, the question left is simple. Where does the trade-off trade off? How much of a debt bubble will the RBA inflate to achieve its 2–3% target? How low can interest rates go before Glen Stevens’ hair catches fire on the interest rate limbo stick?


Nick Hubble
For Markets and Money

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Having gained degrees in Finance, Economics and Law from the prestigious Bond University, Nick completed an internship at probably the most famous investment bank in the world, where he discovered what the financial world was really like.

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