These days formulating monetary policy, which is set by the Reserve Bank of Australia (RBA) and other central reserve banks such as the US Federal Reserve, may give the impression that it is a sophisticated process and an exact science. It’s reasonable to think that these micro-adjustments of interest rates are to ensure that our economy will stay healthy and that the changes are set to perfection.
If we were to put together a list of criteria that we thought could be the objectives of the RBA and other similar operations around the world, it would be fair to consider the following four factors to be important to decision makers:
- A stable and positive economic environment.
- A stable and positive employment and wage situation.
- A stable and fair cost of capital, for borrowers not paying too much, and investors or lenders being fairly rewarded for the risks they take on.
- A stable housing market where ownership is available to the average Australian in key capital cities.
If we take a scientific approach to this broad range of criteria over the past 100 years, the question arises as to whether they are being met over the long term. Or are we just see-sawing through the boom–bust–recovery–repeat cycle?
It is fairly early days, but questions are starting to be asked about monetary policy:
- Are the interest rate changes by the RBA (and others) a blunt instrument or a precision tool?
- Does the changing of interest rates discriminate between segments of the population?
- Are there more effective methods to regulate the economic health of our nation that should be applied first?
Let’s take a simple and recent example. Typically, when a housing market or economy got too heated, in the past the RBA would step in and gradually increase the cost of capital on borrowers by raising interest rates.
Now, the trade-off with this is that households are affected – and some might say hurt – financially. People on very tight budgets find they struggle to make ends meet, whereas people on high incomes who have surplus income are possibly less affected. The flip side of this is that lenders and investors make an instant higher rate of return on capital, either through loans, a term deposit or other fixed-interest investment.
The question is, has monetary policy targeted or discriminated against a specific group of the population, or was the pain felt equally across society for the greater good?
In more recent times we saw a change of approach, which I am not sure was deliberate but it highlights why I believe we should be thinking about this problem a different way.
Recently we saw APRA step in and raise the service rates that banks apply to evaluate a loan. The interest rates for existing borrowers did not change, yet any new borrowers, who were likely to be buyers of property, are now subject to a tougher lending regime. These new borrowers do not pay a higher interest rate, but are subjected to much tougher lending criteria.
This subtle change might have been one of the key reasons for the cooling and then stabilising of the housing market, which had started to overheat. If borrowers collectively can’t pay more for property, then prices will naturally adjust to meet this new status quo.
So was this approach more equitable for the citizens of Australia than the change in interest rates as in the earlier example?
At the time of writing this article, the market is forecasting further interest rates cut by the RBA, which will drop rates to ultra-low levels.
If this strategy plays out, it will likely favour anybody who has a home loan, but disadvantage anybody who wants to get a return on their retirement funds. It will certainly place tremendous pressure on retirees who invest capital into the markets to obtain a reasonable rate of return on the fixed-interest part of their portfolio.
My issue with this kind of monetary policy is that it directly and unfairly targets segments of the population.
The reality with monetary policy is that in most cases it is not black and white. Each change has a widespread knock-on effect on the economy and on citizens. Not enough work has been done in this area to properly consider these effects and ensure a socially equitable outcome.
Today the RBA cash rate sits at 1%. If the status quo of the boom–bust–recover–repeat cycle continues, we have historically used around 3% in cuts to interest rates when a meltdown occurs. So we don’t have much to play with, as a 3% cut would take our RBA cash rate into negative. You only have to look at Germany and Switzerland to see the reality of negative interest rates – so it’s not as crazy as it sounds.
Right now, Australian and New Zealand are apparently considering the option of using Quantitative Easing – otherwise known as QE – as another tool.
In our view this would be the equivalent of a nuclear bomb monetarily and societally. The main reason I say this is that it is effectively ‘printing money’. The ‘treatment’ is to try to stimulate the economy by injecting massive amounts of liquidity into the financial system: rather like gulping down a Red Bull.
Like any ‘quick-fix’ medicine, there are always side-effects. With QE, one side-effect is that it can inflate asset prices both of property and shares.
In my view this is troubling as it can widen the wealth gap. People who have assets can benefit significantly, whereas people who have little find attaining assets becomes further from their reach.
Populations that have very wide gaps in social structure often results in unstable political environments and general societal unrest. One might refer to this as the ‘populism cycle’. Social unrest has a history of reoccurrence. We have already seen the effects of this around the world, where housing becomes unaffordable and making ends meets becomes an insurmountable challenge.
Hopefully, before the RBA pushes the red button, there will be some widespread, open and frank discussion with decision makers and the Australian people about QE.
I would be bold enough to say, in fact, that a referendum on QE should be held, so that society is informed before this tool of mass destruction is unleashed.
Getting a return on fixed interest these days is fairly challenging for the average investor. If you are worried about where to get a decent fixed-interest return and what options might be available, I recommend you speak to a suitably qualified, practising financial planner and of course I recommend you contact AJ Financial Planning.