It’s a simple enough question. What matters more — the level of interest rates or their magnitude and direction of change?
On the one hand, the Reserve Bank of Australia’s (RBA) interest rate remains highly stimulatory. Inflation is running at about double the central bank’s interest rate, after all. That means borrowers can borrow money, buy widgets, and profit handsomely from mere inflation alone.
This should be rather good for the economy. At least the parts of it that are impacted by debt-financed spending.
Of course, that’s not how it works in reality — especially with house prices plunging. But does it even work that way, theoretically speaking?
Since interest rates hit zero during the pandemic and stayed there until 2024 2022, the RBA has hiked fast. The consequences make for a lot of dramatic news headlines.
News.com.au has a story titled, ‘I bought a home at 22, now I’m in trouble’. It goes on to explain that ‘overnight, Jade Lyndal’s interest rate doubled, now she’s struggling to make ends meet’.
Sounds to me like the theory of low interest rates isn’t working out so well for Jade. It sounds like the direction and speed of travel of interest rates matter more than their level relative to inflation.
Why does that matter? Apart from Jade’s well-being, of course…
Well, central banks worldwide, with the notable exception of Japan, have embarked on an epic rate hiking cycle. They’re hiking far and fast. This is despite extraordinarily large debt burdens in their respective economies.
They’re trying to tighten monetary policy to rein in inflation. But, as I’ve just pointed out, it’s not entirely clear what ‘tight’ monetary policy actually is.
On the one hand, historically speaking and especially given the rate of inflation, interest rates are still very low. This implies plenty more rate hikes are needed to get inflation under control.
Alternatively, the speed and extent of the rate hikes are blistering. It’s so fast that they risk breaking something…or someone like Jade. A bit like in the US between 2003 and 2006, when a comparatively moderate rate hiking cycle triggered a memorable experience for property investors.
So, which is more important? The level of rates or the hiking itself?
Another theory claims that’s the wrong question to ask in the first place. It argues that there is a hypothetical and unknowable level of interest rates that is ‘neutral’ — neither stimulatory nor hawkish for the economy. What really matters is whether the interest rate is above or below this unknowable number.
Keep interest rates below this figure, and you get inflation and/or housing bubbles. Keep it too high, and you get a recession.
Under this school of thought, you can’t tell whether monetary policy is loose or tight based on the interest rate alone or its direction of travel. You can’t tell, period. Because knowing what the neutral rate might be is impossible.
Because of this, the price of money (the interest rate) should be left to the free market. The same one that determines far more important prices, such as food, every day.
Why don’t we have a central food bank setting food prices? Because we wouldn’t trust them to get it right. And yet, we trust central bankers to set the interest rates just right. Well, we believe we need them to do it, anyway.
So let’s not kid ourselves. No matter how clueless central bankers are proven to be, they won’t give up on meddling with interest rates.
Room to fall
If it’s the rate of change in interest rates that really matters, this also explains why prolonged periods of zero interest rates since the global financial crisis didn’t stimulate diddly squat in much of the Eurozone economy.
And it suggests that monetary policy requires room to cut in order to function during a downturn. You have to be able to lower interest rates to fight off a recession, not just have low rates.
That’s because every mug who’s willing to borrow at 0% interest rates has already fallen for it. To get an additional borrower sucked in, you need to go even lower.
With much of the developed world facing a recession and the corresponding interest rate cuts that go along with it, this creates some important conclusions.
The US Federal Reserve, thanks to a rate hiking cycle that was so fast it blew up its bond and stock markets in the first half of 2022, has room to cut rates. It can lower them to fight off a recession.
The UK and Australia were laggards regarding rate cuts, but there’s still room to lower rates.
The Eurozone? They’ve barely started hiking rates. And so, with European economies going into recession, they won’t be able to cut them much either.
This implies the Europeans will struggle more with their coming recession.
As for the Japanese, they’ve given up on inflation to focus on funding their government at 0% rates and keeping the yen off the floor as a result.
So each economy is peering into the recessionary abyss from a different level of interest rates. And should fare differently as a result.
Of course, the timing is not quite the same. The US had two consecutive quarters of shrinking GDP in 2022 — the definition of a recession for everyone except the US economy.
And it’s important to keep in mind that monetary policy works with a lag. A lag that isn’t the same across economies.
US mortgages are largely fixed, so the higher rates apply less to indebted households and more to borrowing capacity and corporate borrowers.
In Australia, variable rates dominate, but only after fixed periods. We’re seeing the first pandemic borrowers hit interest rate reality now. Plenty more to come!
In Europe, the mortgage T&Cs vary wildly. As do the sovereign debt levels…
Imagine having to set one interest rate for economies with completely different debt levels and mortgage rate setups…
For now, the Australian economy is rapidly growing, even if the recent GDP figures were a mild disappointment. We’re almost back to pre-pandemic trendline GDP, according to one graphic I spotted on the news.
This is a little odd if you ask me…
The rest of the developed world is descending into recession…
Australian building companies are going bust left, right, and centre…
House prices, supposedly an engine of wealth and spending, have fallen badly…
The cost of living is surging, forcing people to cut back…
Interest rates are yanking money out of people’s pockets…
Wages are not keeping pace with inflation…
China keeps locking down…
And there’s probably plenty more I’ve missed.
This isn’t a recipe for success, but the pie still seems to be growing, according to the statisticians. Well done to them, however they did it.
Until next time,
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Nickolai Hubble,
Editor, The Daily Reckoning Australia Weekend
