Monday, August 5, 2019

Are low interest rates bad? It depends on your perspective

Although media coverage invariably assumes that low interest rates are good news, they’re now so low there’s a backlash, with people pointing to the disadvantages of low rates and getting quite worried.

The fightback is coming at the usual level of complaints from the retired, but also from more sophisticated observers, such as Andrew Ticehurst, of the Nomura banking group, and Dr Stephen Grenville, a former deputy governor of the Reserve Bank.

It’s understandable that the retired and other savers object to the Reserve Bank’s decisions to cut interest rates and are particularly exercised now rates are so close to zero. Doesn’t the Reserve understand we live on our interest income? Of course it does. So why does it persist?

Interest rates are the price borrowers pay lenders (and, ultimately, savers) for the use of their money for a period. Clearly, cutting rates benefits borrowers at the expense of savers. Central banks cut rates to encourage borrowing and spending because they know the expansionary effect on borrowers greatly exceeds the contractionary effect on savers.

They’ll never be dissuaded from this approach. It’s true interest rates are a “blunt instrument”, but they’re pretty much the only instrument central bankers have.

The retired are on much stronger ground when they insist the government continually updates the “deeming rates” it uses to assess the effect of people’s savings on the amount of their part-pension. It’s surprising the grey lobby has taken so long to wake up to this.

The more sophisticated criticism is that, though market economies thrive on risk-taking (and this is one of the mechanisms by which lower rates are expected to stimulate demand), unduly low rates encourage excessive risk-taking.

Businesses are encouraged to become dangerously highly “geared” or “leveraged” (too dependent on borrowed capital rather than share capital) and firms invest in projects that are high-risk or are profitable only if the cost of borrowing is unrealistically low.

In both cases, the seeds of the next bust are being sown. When rates go back up, firms and projects will fall over and there’ll be hell to pay. Very low rates also allow the survival of “zombie” firms – those that have failed and should have died, but are still living – which tie up resources that could be used more efficiently elsewhere.

Running “ultra-loose monetary policy” at a time when demand is weak can do more to cause dangerous bubbles in share, property and other asset markets than to stimulate markets for goods and services.

There’s merit in these arguments – in normal times. But this brings us to the key question of our times: are our present troubles cyclical or structural? Is it just taking frustratingly long for the economy to return to the old normal, healthy rate of growth, or have so many major (but, as yet, not fully understood) changes occurred in the structure of the economy that a “new normal” has arrived, requiring us to get used to a much lower rate of growth, complete with permanently lower inflation and interest rates?

Treasury is sticking firmly to the view that we’ll soon return to the old normal (thus adding weight to the critics’ worries about the bad seeds being sown by protracted low interest rates) and so is the Reserve – except that governor Philip Lowe’s recent exposition of the reasons for persistent low inflation had a bob each way, nominating cyclical (spare capacity) and structural (effects of digitisation and globalisation) factors.

Remember, interest rates come in two parts: the borrower’s compensation to the lender for the loss of their money’s purchasing power while it’s in the borrower’s hands (the expected inflation rate) plus the borrower’s payment to the lender for the use of their money during the loan (the “real” interest rate).

For as long as inflation stays low, nominal interest rates will stay low – without any real loss to savers, even though their susceptibility to “money illusion” (forgetting to allow for inflation) means many don’t realise it.

And here’s something many people haven’t realised: globally, real interest rates have been falling since the 1970s and are still falling. Harvard’s Lawrence Summers finds in a recent paper that real rates have declined by at least 3 percentage points over the past generation.

Put the two parts together and interest rates – both nominal and real – look like staying low for a long time, whether we like it or not. This says many formerly unprofitable investment projects are now profitable, and budget deficits and high public debt are now much less worrying.

The critics imply the Reserve has great freedom to keep the official interest rate high or low. Not really. It can’t defy economic gravity. It’s the Morrison government that could, at the margin, use its budget to reduce the pressure on the Reserve to cut rates further.