Why interest rates need to normalise (and rate hike fears are unfounded)

Back in June 2019, the Reserve Bank of Australia Board meeting minutes stated that “households are net borrowers in aggregate”. This, in turn, contributed to their view that on balance “a lower level of interest rates was likely to support growth in employment and incomes and promote stronger overall economic conditions.”

I subsequently wrote to the RBA and sought clarification, given that households are not net borrowers in aggregate. 

The central bank’s response indicated the comment was in reference to interest-bearing net borrowings, rather than total net borrowings. Perhaps this was the intention of the authors, but the fact this qualification is missing from the minutes means the statement remains incorrect – households are in fact large net savers in aggregate.

The above point is important. There is currently a general perception that high levels of debt in the private sector preclude the RBA from materially lifting interest rates. This view appears to be reflected in the current yield curve, with 10-year government bonds yielding 1.9%. This remains below the RBA’s target range for inflation and the bond market’s expected long term inflation rate of 2.3%.

So, bond market pricing assumes monetary policy will remain very loose, with the general level of interest rates remaining below inflation for most of the next decade. In other words, bond markets are assuming negative real rates will continue.

The conventional view that lower interest rates will boost spending and higher rates will restrict spending is a key underpinning of both the RBA’s statement above and bond market pricing in general.

The efficacy of this relationship, however, has been brought into question over the past decade. During this period, the spiralling down of rates to record low levels failed to boost spending in any meaningful way nor increase inflationary pressure.

• In the decade ending December 2010, the cash interest rate averaged 5.2%, which coincided with an average rate of growth in real household consumption spending of 3.8%.
• In the following decade ending December 2020, the cash rate average had dropped to 2.2%, with household spending growth languishing at an average growth of 1.5%.

A lower propensity of households to spend, despite the materially lower interest rates in place, is indicated by a rise in the average household savings ratio over the two decades from 1.9% to 7.5%.

This highlights the complexity of the relationship between interest rates and spending, which may not follow expected conventions. This seems particularly true when interest rates are very low.

Following are three examples of factors that may have worked against lower interest rates stimulating spending in the way policymakers would have expected over recent years:

1. Clearly, retirees living off interest income have their spending constrained by lower interest rates. However, in addition, those approaching retirement are required to accumulate larger savings in a low interest rate environment in preparation for lower interest earnings in retirement. So, while pre-retirement age groups may have few assets that are interest-rate sensitive (the majority is likely to be held in the form of property and equities), the lowering of interest rates may lead to lower spending and higher savings by this cohort.
2. At the other end of the age scale, first home buyers are typically required to save larger deposits once low interest rates are in place, given the tendency for housing prices to rise as interest rates fall. Again, this group’s spending may be negatively impacted by lower interest rates, despite them having a relatively low pool of interest-bearing assets (or liabilities) prior to making the purchase of a house.
3. Those households with existing loans are the group most expected to increase spending when interest rates fall. However, in reality, there will be a mixed response to lower interest rates by borrowers. Many will maintain existing repayment levels and run-down loan principal. Others will hold larger balances in mortgage offset accounts to further reduce interest expense. Increasingly over recent periods, some borrowers have opted for fixed-rate loans, removing the conventional link between policy interest rate levels and spending levels.

Over the last decade, lower interest rates have failed spectacularly in moving inflation. This brings into question the same approach for the years ahead, where only incremental rate movements are hoped to have the necessary moderating effect on inflation. Perhaps larger interest rate increases will be needed to really move the needle on spending and inflation?

How high can interest rates go?

A common counter to the above view, that interest rates need to return to “normal,” is that debt levels are now so elevated that the real economy cannot sustain such normalised rates.

Having purchased my own first property in 1990, when I subsequently dealt with mortgage rates in the 15% to 16% range, the proposition that the economy has minimal capacity to absorb a cash rate not much higher than 0.1% certainly deserves some critical analysis!

While government debt has clearly ballooned in recent years, borrowing by the private sector has been far more constrained. In fact, the relatively slow rate of expansion in private sector credit is one reason why loose monetary policy over the past decade hasn’t been accompanied by higher spending and inflation.

In September 2021, the level of private-sector borrowings outstanding was $3.2 trillion, or 1.5 times the annualised Gross Domestic Product of the Australian economy. Ten years earlier, the ratio of borrowings to GDP was 1.4 times. This is a stark illustration of the benign growth in the relative size of credit outstanding, given the magnitude of the decline in the price of credit (interest rates).

Part of the explanation for the relatively muted rate of growth in credit is the high rate of principal repayment on loans, which has been facilitated in part by record-low interest rates.

The household balance sheets of existing borrowers have clearly improved. But even if we ignore this and focus on the position of recent first home buyers (the group most vulnerable to rate rises), the evidence still suggests there is the capacity to absorb interest rate increases.

In the 10 years to 2021, the average size of loans approved for first home buyers has increased from $318,000 to $455,000. Despite the high principal balance, lower interest rates have meant that the interest servicing cost on these new loans has fallen from $24,800 to $20,600 per annum over the same period (assuming standard variable home loan rates – currently 4.5%).

At the same time, wages have increased, resulting in the interest servicing cost as a percentage of the average wage declining from 35% to 22%. So, much of the pain of higher housing prices for first home buyers has been felt via a much larger deposit requirement, rather than the size of the loan repayment.

With interest rates at only a fraction of their levels during past economic cycles and only a very measured increase in private sector debt, there seems to be considerable capacity for the private sector to absorb higher interest rates. If so, the current policy of holding cash interest rates at an artificially low level is going to become increasingly difficult to justify.

Economies have typically operated well when the prevailing level of interest rates is above that of the rate of inflation. Positive real interest rates provide the incentive for capital accumulation and subsequent investment in productive assets.

A prolonged period of negative real interest rates will increasingly direct investments to real assets, such as property. In such assets, the stream of rental income is inflation-linked and destined to compound at a higher rate than the cost of capital (the interest rate).

If rents rise faster than borrowing costs over the longer term, almost any capital value for the real asset can be justified mathematically (Sydney real estate is a prime example). 

With these metrics in place, the incentive to invest in productive assets, such as machinery, which depreciate over time, is reduced on a relative basis.

The long-term policy objective of central banks should be to return the general level of interest rates beyond the level of inflation.

Over such a timeframe, inflation in the range of 2% to 3% appears increasingly likely. In the past, cash rates have averaged approximately 1% higher than inflation. In addition, typically, the shape of the yield curve is positive, with 10-year government bonds being an average 0.6% higher than the cash rate.

As such, a cash rate of 3.5% and a 10-year bond yield of 4.1% should not be considered extraordinary. But this is a long way from current bond market pricing and, indeed, central bank guidance.

With the labour market currently strong and job vacancies at record highs, the rationale for delaying the normalisation of interest rates is increasingly unclear.

The prices being paid for the current policy include:

• inefficiency in resource allocation,
• inequity in wealth distribution, and
• lower rates of homeownership.

These considerations will start to weigh more heavily on central banks in the absence of the case for “emergency settings”. Positive real interest rates are needed for long term economic efficiency, growth and equilibrium and should not be feared by central banks, nor indeed share market investors.

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