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Are interest rates unnaturally low? Or are they where they should be?

July 24, 2017

July 24, 2017

By Tim Farrelly – CEO of Farrelly’s, and asset allocation consultant to Australian Unity Personal Financial Services

We hear the claim that interest rates have been kept unnaturally low by Central Banks around the world with the clear implication that no good will come of this and, before long, they will be forced to take them back to more natural levels. These comments ignore the actual role of Central Banks. Their mandates are typically to keep inflation under control and to keep employment full. This aligns with Kurt Wicksell’s 1898 notion of a natural level of interest rates where inflation is stable and employment is full.

Now, if we are to believe that Central Banks have artificially kept rates below the natural level for much of the past decade, then we should be seeing booming economies, incredibly tight labour markets, rampant wage inflation – all resulting in a 1970s style wage-price spiral. In practice, we don’t see any of this at the moment, anywhere. The closest we get is in the US where employment is full but with little signs of any inflation breakout. And guess what? The Fed is raising interest rates in response. Exactly as it should be doing.

Yes, rates are unusually low. Undeniably. But to describe that as unnatural is basically a refusal to accept that maybe, just maybe, the world has changed and that Central banks are doing what they should be doing in this new world. Far better to try and understand why the world may have changed and then recalibrate from there.

Firstly, there is the impact of very high debt levels. We know that in Australia and New Zealand, the amount of household debt – largely housing related – is at record levels. Since 1997, Australian household debt-to-GDP has doubled. That means that the economy’s sensitivity to interest rates changes has also doubled. Households simply don’t have the ability to pay much higher interest rates. That is a real factor that will help keep rates low.

A small rise in interest rates will have an outsized dampening effect on the economy. And then there is the fact of low inflation and, in particular, low wage inflation. Globalisation, technology, and the weakening of the union movement are all playing a part in keeping wages growth low.

Until we see a change to one or more of these factors, it is hard to see a wages breakout – the key pre-condition to an inflation breakout. So, we are where we are. Interest rates are at historically low levels and Central Banks should be applauded for having the courage to go where none have gone before. Furthermore, interest rates are likely to remain low – naturally – for a very long time.

This is not to say that all is well with the world. Far from it. But the idea that we should be expecting a return to the old normal level of interest rates as soon as those arrogant central bankers stop interfering with markets is one we should treat with a great deal of caution. This is not a time for growth investors to be fearful of large interest rate rises. Similarly, for income investors hoping for a return to the good old days of high interest rates, you could be waiting for a long time.

Are you thinking about investing in property but not sure if its right for you?
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Michelle Roberts

Advisor

  • Bachelor of Business (Property Investment)
  • Advanced Diploma of Financial Services (Financial Planning)

Michelle Roberts is an Authorised Representative of Australian Unity Personal Financial Services Limited (AUFP) ABN 26 098 725 145, AFSL 234459. 

This article is not legal advice and should not be relied on as such. Any advice in this document is general advice only and does not take into account the objectives, financial situation or needs of any particular person. You should obtain financial advice relevant to your circumstances before making investment decisions. Where a particular financial product is mentioned you should consider the Product Disclosure Statement before making any decisions in relation to the product. Whilst every care has been taken in the preparation of this information, Australian Unity Personal Financial Services Ltd does not guarantee the accuracy or completeness of the information. Australian Unity Personal Financial Services Ltd does not guarantee any particular outcome or future performance. Australian Unity Personal Financial Services Ltd is a registered tax (financial) adviser. Any views expressed are those of the author and do not represent the views of Australian Unity Personal Financial Services Ltd. If you intend to rely on any tax advice in this document you should seek advice from a tax professional. Australian Unity Personal Financial Services Ltd ABN 26 098 725 145, AFSL & Australian Credit Licence No. 234459, 114 Albert Road, South Melbourne, VIC 3205. This document produced in April 2017. © Copyright 2017