We touched on interest rates on Wednesday, but it’s worth revisiting today.
Last night the Bank of England dropped interest rates to 1.5%. That’s the lowest rate in the 315 year history of the UK’s central bank. Since the BoE was established in 1694, interest rates had never previously fallen below 2%.
What about the Reserve Bank of Australia (RBA)? They’ve got more room to move. But before we get onto that, let me just summarise what has happened overseas.
The US Federal Reserve is already trying to go as low as it can. The last Fed decision was to set a range of 0-0.25%. According to the data from the Federal Reserve Bank of New York, the average overnight rate has been about 0.1% since the Fed changed its policy.
And it looks as though the UK could be following suit. Economists and analysts in the UK seem to be looking forward to the BoE cutting rates even further. 50 basis points this month. Another 50 basis points next month? Maybe even 75 basis points. Who knows?
As Complicated as Printing Money
The next step? Printing money. Or as the BBC website tells us, “Printing more money is a simple shorthand for a more complicated process called quantitative easing.”
You could look at it that way. Or you could say that “quantitative easing is a complicated way to describe the simple process of printing money.”
Here’s how the BBC describe the process of “printing money”:
The Bank of England would write out cheques to banks in exchange for assets (for example, government bonds or corporate investments.
The hope would be that the banks would lend this money to all of us. We would spend it and therefore boost the economy.
The government could also create more bonds (known as gilts) and sell them to the Bank of England.
So the government receives money, which it then invests in the economy via spending or tax cuts.
We can sum it up in one simple phrase, it’s ‘Economics for Dummies.’ Expect to see this latest ‘Dummies’ book authored by the world’s central bankers and their economist fanbase in all good bookstores later this year.
The difference with this one is that rather than showing you what to do, it will highlight what NOT to do.
The Road to Zimbabwe
One of the problems with this policy is the potential for it to drive up inflation. It could even create hyperinflation such as they have in Zimbabwe where as of July last year the CPI was running at 231,150,888.87%. But at least they don’t have low interest rates.
Thanks to a CPI of 231 million percent, interest rates are now at an overnight rate of 10,000%. Because of course, in order to try and bring inflation back into line, interest rates need to rise.
So while there is all the talk about deflation being evil and inflation being good, spare a thought for the Zimbabweans and consider that we could be heading down that path if central banks let inflation get out of control.
But as I wrote above, the RBA does have a lot more wiggle room (or is it wriggle room?!). Although we also thought the same thing when the US and UK had their rates at 3, 4 or 5%.
The problem with trying to manipulate the interest rate markets is that not only can it have the potential to go completely pear-shaped but it can have the desirable effect of showing the consumer the benefits of paying down debt.
Banks May be Doing You a Favour
Take mortgage repayments as an example. Did you know that despite Australian interest rates having fallen from 7.25% to 4.25% during the last few months many variable rate borrowers are still making the same repayments each month?
“That’s criminal” you cry. The banks should be passing on the mortgage rate cuts.
They have. Read that passage again. “Borrowers are still making the same repayments.” What has changed is the amount of interest charged. You see, most banks do not reduce the monthly repayment amount in the event of a drop in interest rates.
This means that if you were previously charged $1,450 per month in interest, your monthly repayment may have been $1,500 to cover interest and some of the principal as well. That may take you 25 or 30 years to pay off.
But what happened when interest rates were cut? All of a sudden, the interest charge has fallen to $1,100 per month yet your monthly repayment has stayed at $1,500.
Suddenly you have gone from paying only $50 a month in principal to $400 per month. The impact on the length of your mortgage is no less dramatic. Instead of being the proud owner of a house in 25 years, it is suddenly down to around 15 years.
Don’t believe me? Take a look at the loan calculators on any bank’s website. Or even better, take a look at your own mortgage.
Debt Reduction: The New Craze for 2009
The impact of all this on the indebted is that it can change their outlook. A year ago they were looking at the biggest and best plasma, or a brand new car, today they are thinking about postponing those purchases and paying more off the mortgage instead.
Long term this is good. However, not surprisingly politicians and central bankers are doing their utmost to through a spanner in the works. Sure, it is their interest rate policies which are giving this break to those in debt, but by their comments they are encouraging spending instead of debt reduction.
Further, in case the public does not respond they are doing the spending for them – bridges, hospitals, roads, etc. – which can only lead to inflation, higher public debt and eventually higher taxes. (it’s got to be paid for somehow).
The sensible strategy at this stage would seem to be not to join the inflationary bandwagon and instead pay off as much of that housing debt while you can.
You’ll need all the free cash you can in a few years to pay the higher prices and higher taxes.
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