Today the Reserve Bank held interest rates at their current 60 year low, 2.5%. Was that because they haven’t a clue what to do next? … when in doubt, do nothing?

Within minutes, my phone and email was alight with the ritual unsolicited (pre-written) “news” from all over the place: property gurus; banks; finance brokers. Without exception they offered nothing new. Most just spouted their party line.

This post is not one of those …

This pre-occupation (obsession even) with this month’s interest rates seems absurd.

I have never seen any clear evidence of sensible people making business or personal decisions about how much debt they will take on based on what the interest rate is in any particular month. Let’s take a look …

First let’s look at personal/household decisions.

• These days if folk need or want something for consumption – food, clothes, flat screen TV, holiday, whatever – they either have the money, or they go into debt. If the latter, they use a credit card, or some form of unsecured personal debt on which they pay very high interest rates (18% or more). Their decision process cares little for the RBA rate: it’s irrelevant.
• If they want or need to make a medium sized purchase – new car, swimming pool, another bedroom – any debt used will be secured against the purchase itself (the new car) or very likely equity in a home. In this case the interest rate will be much lower. But, the two key decision factors are: how badly do I want/need this thing; and, can I service the whole loan from income over five or ten years. Today’s interest rate is only a small element of that decision, because hungry/greedy lenders go to great lengths to structure the periodical debt repayments to the borrowers forecast income, so they can make the loan regardless of the interest rate. Again, the RBA rate is pretty irrelevant.
• Then the big one: buying a house and taking a mortgage. I have yet to see a normal mortgage driven household take a mortgage and buy a house where the size of the mortgage wasn’t determined fundamentally by the household’s income. The logical consequence is that lower interest rates mean borrowers can afford a higher principal; with higher interest rates, a lower principal.
• Simple really … so how does that play out in the housing market:
  • When interest rate are low, more buyers can afford a house. More demand entering the market seems mostly to mean higher prices. (Look at Sydney now.) Matching new supply is very slow entering the market, and is anyway constrained by so much more than interest rates.
  • When interest rates are low, buyers who could already afford a house tend not to buy a suitable lower priced house and save on mortgage payments – they spend more and buy a bigger one!
• So, to a significant extent, low interest rates just drive up demand and house prices, add to the total quantum of debt, and store up huge economic and social problems (for mortgage holders and banks) come the day interest rates rise again.

To me, all the above means that the Reserve Bank is on a hiding to nothing with consumers. If the consumer is “stimulated” by lower rates, he will just rack up debt and spend it on things he can’t afford in the long run. Not a good outcome for the Reserve or the consumer. On the other hand the cautious consumer may refuse to be “stimulated”, and the bluntness of the RBA’s only tool “to get the economy growing” is exposed.

Now a quick look at real business investment.

The backbone of the economy, they say, is small business. Show me the small business where it’s success stands or falls of a couple of points of interest on the amount of debt they have. I’m sure you would struggle.

Small business succeeds or fails because it’s a good idea, fulfilling a market need, well managed … or not! The RBA’s low rate will not encourage someone to start or grow a business that would not start or grow if the rate was double.

And what about the big end of town? Well here the RBA’s rate today is even more irrelevant. Investments are made in productive capacity (factories, mines, buildings) on the basis of complex mixes of retained cash, new equity and debt funding that pay little heed to the interest rate in the here and now. These are decisions for the long term that require judgments about the average cost of capital in the long term.

So the circus surrounding the monthly board meeting of the RBA is just that … a circus. Just like the in the USA, the relevance of the monthly setting of interest rates is really only relevant to the speculative markets, not the real economy.

The RBA the Federal Reserve and central banks everywhere are nearly powerless when it come to goosing the the real economy. And, in the process of trying, they have laid, and are laying down the foundation for huge problems ahead …