5 Reasons Artificially Low Interest Rates Suck Long-Term

After 18 months of historically low interest rates, the Reserve Bank of Australia (RBA) just knocked an additional 25 basis points off the cash rate. Many expect another rate cut to come later this year.

Property investors and home owners with a mortgage have something to get excited about. All the major banks and two dozen other lenders have passed on the interest rate reduction:

• Australia and New Zealand Banking Group (ANZ) is down 0.25 percent to 5.63 percent, effective Feb 12.
• National Australia Bank (NAB) is down 0.25 percent to 5.63, effective Feb 20.
• Commonwealth Bank of Australia (CBA) is down 0.25 percent to 5.65 percent, effective Feb 20.
• Westpac is down 0.28 percent to 5.7 percent, effective Feb 20.

Why Did The RBA Lower The Cash Rate?

So, what’s up with the rate cut? The economy seems strong enough. Petrol is cheap, the housing demand is strong, seek.com.au has plenty on offer, and the shopping centres are full of people spending money.

Well, apparently, the RBA smells trouble. One of their stated goals is to keep inflation in the two to three percent range. Plummeting oil and natural gas prices, which the consumer loves, have been putting negative pressure on the inflation rate, which the RBA hates.

The RBA has also been saying for some time that the Australian dollar has been too high in light of sharply declining commodity values. China’s weakening steel industry has killed iron ore prices, which is threatening our economy as a whole. The hope is, if they can make the Aussie dollar weaker, our stuff will be cheaper for people overseas to buy, which will boost our export market.

But there are no free rides. While this may bring some short-term gain to mortgage holders and exporters, artificially low interest rates will lead to longer-term pain for the majority of Australians. Don’t believe me? Just ask RBA Governor Glenn Stevens who only six months ago said:

“…although popular commentary just regards lower interest rates as always better, that is not really true for significant parts of the economy; it is actually bad for significant parts of the economy.

To elaborate on what Governor Glenn calls, “significant parts of the economy,” here are five reasons artificially low interest rates suck long-term:

1. Retirees Living Off The Interest Of Their Savings Get Kicked In The Teeth

Retirees depend on income from low-risk investments to fund their retirement years. Just five years ago, they could earn eight percent off a term deposit. Now it’s more like three to four percent if they’re lucky, meaning many retirees have lost half of their income.

In the same speech I referred to above, Glenn Stevens added these remarks,

“Right now, the savers are feeling the pinch of very low rates of interest on the safe assets that they hold and they are being prompted in many cases to accept a little more risk to get the return they are seeking… other than under the most extraordinary circumstances, one might think that there may be some point at which you do not want to keep punishing the savers too much further.”

Apparently last Tuesday we entered the realm of “extreme circumstances.” Retirees were already being punished when the Governor made these statements prior to last week’s rate cut. Now they’re getting kicked in the teeth. By the end of the year, they may be unconscious on the mat.

2. Unskilled Investors Take On Greater Risk To Get The Same Return

In addition to bank deposits, savers sometimes park assets in low-risk government bonds. Lower interest rates lead to lower bond yields.

As interest rates decrease, many bond investors transfer a higher percentage of assets into the share market in search of higher yields, exposing them to greater risk.

These transfers can push up the value of the share market, even when the underlying companies are not performing well and not fundamentally strong enough to justify their value.

This, in turn, leads to an asset bubble in the share market, which heightens investor risks all the more. When the bubble eventually bursts, investors who couldn’t see the writing on the wall will end up losing.

3. First Home buyers Find It Harder To Save For A Deposit

Lower interest rates also lead to asset bubbles in the property market. When the cost of borrowing is diminished, investors become more motivated to enter the market, while some homeowners may even upgrade their personal residences.

This creates greater demand in the market, which lifts property prices.

The more expensive a home is, the greater a deposit the buyer needs, which squeezes first homebuyers out of the market. They find it increasingly more difficult to compete against those who already own a home and who’ve benefitted from a few decades of strong growth.

This in the end leads to greater wealth disparity, as the winners are those who hold and know when to sell them, and those who don’t lose.

4. Stuff We Buy Gets More Expensive

This is called inflation and is tied to the value of our money. The RBA likes inflation in small doses, and so they seek to moderate the consumer price index through the manipulation of interest rates. You can learn more about the mechanics of this here.

Long story short, to decrease interest rates, the RBA increases the supply of money, which makes our currency less valuable. You in turn need more of it to buy stuff. We’ve seen this devaluation of the Aussie dollar over the past few years, dropping from around a dollar to as low as 76 cents last week.

Sometimes we feel inflation immediately, like when we buy stuff online directly from overseas. Other times, it takes a few months before importers pass on their costs to us, the consumers. If you’re in the market for a new television or any other imported appliance for that matter, now is the time to buy, before the most recent dollar devaluation gets passed on to the consumer.

Most things increase in price gradually. Even items that we grow and produce here at home eventually become more expensive, because of the knock on effect from importer to producer to consumer. As long as this increase is gradual and corresponds to an increase in wages, no one really complains. But if inflation spirals out of control, there will be pain.

5. Short-Sighted Home buyers Overextend Themselves

Property investors and those seeking to buy a home to live in hear about historically low interest rates. They tend to think they can afford to borrow more than they could borrow a few months ago. Forgetting that rates will inevitably rise, they get caught up in the euphoria of a rising market and base their budget on today’s rates.

As I wrote about here, all things tend to revert to their mean. In other words, over time, interest rates will tend to move toward their historical average.

The average standard variable home loan rate in Australia between 1990 and 2010 was 8.54 percent. Go back farther and the average will be higher.

What would happen to the average person in Australia if their mortgage interest payments doubled? Pain.

Conclusion

While the RBA can prop up employment and normalize inflation for the short-term, the jury’s still out on what the long-term impact will be on these historically low rates.

In these uncertain times, it’s important for you to continue to focus on your education. Every investor should understand the impact of broader economic factors, know how to quantify risk and learn how to create profits, regardless of what the broader market is doing.

By Jason Staggers

Jason was a personal mentor working with Steve McKnight's Property Apprentices. He helped hundreds of investors apply Steve's teachings in the real world and achieve greater results on their journey to financial freedom. Jason now lives in Perth, WA where he leads Neuma Church.