What Central Banks Won’t Tell You About Interest Rates

The US has plenty to teach Australia about the downsides of loose monetary policy. It knows a thing or two about it, after all.

US interest rates have been at near zero for nine years. In that time, savers have suffered and business investment has tanked. Yet the US economy hasn’t improved in any measurable way. It’s sitting on mountains of debt, even while economic problems persist.

Low rates have long been the prescribed remedy for economies. The more you lower, the better an economy’s growth prospects. Or so the theory goes.

The Reserve Bank (RBA) follows this mantra too. Aussie rates are at record lows of 2%. Yet the crowning glory of monetary easing is that asset prices have gone through the roof. And savers have been left devastated. The impact on the real economy is less obvious.

Achieving growth in today’s world is harder than it’s ever been. Something the Australian economy is all too familiar with. Yet we’re not alone here. Slowing growth across emerging markets is a problem every economy struggles with. It is, however, a particular problem for Australia.

Commodity exports underpin our prosperity. When growth across emerging markets stalls, as it has, demand for commodities plunge. Prices, and revenues, fall as a result. And we end up in the current situation where 2% GDP growth looks optimistic.

The outcome of this prompts the RBA into action. To the point where rate cuts become inevitable. Rates have fallen three times this year in response to weak commodity prices.

So when the US Federal Reserve left rates on hold this month, eyes turned to the RBA. Suddenly, the onus was back on the RBA to ease rates again.

But the RBA should think twice. It must resist the temptation to slash rates again. We only need look at the US to see why that is.

Business spending and the problem with low interest rates

Economists always refer to the benefits lower rates have on economies. Without fail, the argument always centres on how it benefits exports. Meanwhile, other engines of growth receive little attention by comparison.

Take business investment. Capital expenditures (capex) are one of the main drivers of economic growth. It covers everything from infrastructure investment, to spending on workers. In Australia, our private sector has something of a problem when it comes to spending.

Aussie businesses have slashed spending in response to slowing economic growth prospects. As the potential rates of return fall, so too does capex spending. It’s a significant amount too. In the 2015–16 financial year estimates put these spending cuts at over $100 billion.

But how do low rates really affect business spending?

It’s true that low rates make borrowing costs cheaper for businesses. In theory, that should increase both borrowing and spending levels. Right? Not exactly.

Low rates have an adverse effect that we rarely pay attention to. They put the focus on balance sheets, not capital spending. Here’s Bill Gross, of Janus Capital, explaining this effect:

Zero bound interest rates destroy the savings function of capitalism, which is a necessary, andsynchronous component of investment. If companies can borrow close to zero, why wouldn’t they invest the proceeds in the real economy?

The evidence of recent years is that they have not. Instead, they have ploughed trillions into the financial economy as they buy back their own stock with a seemingly safe tax advantage arbitrage’.

He’s right, of course.

We’ve seen this development spread right around the Australia’s private sector. From banks to miners, companies are borrowing to shore up balance sheets.

Making borrowing cheaper doesn’t ensure businesses will spend on capital investments. It just gives them an excuse to fix their bottom line. Which is why we’ve seen a wave of buyback schemes across Australia’s private sector. All in an attempt to please investors.

Blue chip companies are taking on debt to finance dividends on investors, among other things. And investors seem perfectly happy to go along with this. Despite the fact that everyone knows these businesses aren’t spending on growth opportunities.

But maybe businesses have no choice in the matter. You can’t blame them for spending less when rate of returns are as low as they are.

As for banks, they also face pros and cons. On the upside, low interest rates attract borrowers. But they also lower the returns the banks see too. Which is why some of them are reluctant to pass on lower rates to consumers.

What’s more, it limits banking reserves too, as savers move out into other assets. Instead of promoting term deposits, assets like stocks and property rise to the fore. Mr Gross explains:

Low or zero interest rates, it seems, do wonders for asset prices and for a time even stabilise real economies. But they come with baggage, and as zero or near zero becomes the expect norm, the luggage increasingly grows heavier’.

This same story is playing out across the entire world. From the US, to Japan, Europe and Australia.

Central banks’ monetary easing has been a poisoned chalice for the world. Yes, it has injected capital into the global economy. And yes, it’s propped up economies on the edge of collapse. But that’s as far as it goes. Central bankers haven’t solved any underlying problems. Issues that concern the real economy, and organic growth.

But now the rich world is running out of gas. As Mr Gross explains, investments discounted at near zero rates cannot ‘provide cash flow or necessary capital gains to pay for past promises in ageing society’.

Central banks would be wise to start delivering on their word. If the Fed wants to hike rates, then it should begin as soon as possible.

That would tighten credit in the economy. But at least businesses would have a reason to spend. At this rate, it might be the only thing to get the economy moving again.

Mat Spasic,

Contributor, Markets and Money

PS: The RBA left rates at a record low of 2% in September. According to Markets and Money’s Phillip J. Anderson, interest rates could remain low for a long time to come.

Phil’s written a brand new report, ‘Why Interest Rates Could Stay Low for the 21st Century’. In it, he warns that you won’t be able to rely on your savings to fund your retirement. As Phil says, inflation, from low rates, is eating into your savings. You can’t rely on savings accounts or term deposits for your retirement. The regular return on a term deposit has halved in the last four years alone!

That’s why Phil wants to show you the best way to invest in this low interest rate environment. He’s prepared a four pronged strategy that’ll boost your wealth. You’ll learn where to park your cash over the coming decades to profit immeasurably. To download the report, click here.

Markets and Money offers an independent and critical perspective on the Australian and global investment markets. Slightly offbeat and far from institutional, Markets and Money delivers you straight-forward, humorous, and useful investment insights from a world wide network of analysts, contrarians, and successful investors.

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