Will QE tear apart Australian society?

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:

  1. A stable and positive economic environment.
  2. A stable and positive employment and wage situation.
  3. 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.
  4. 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:

  1. Are the interest rate changes by the RBA (and others) a blunt instrument or a precision tool?
  2. Does the changing of interest rates discriminate between segments of the population?
  3. 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.

What is the impact of negative interest rates?

Run the Red; Run the Risk – How negative interest rates turn economies on their heads.

If you have a home loan or a term deposit, then it is likely that you also have some level of curiosity around what is going on with interest rates.

Each month, the Reserve Bank of Australia (RBA) meets and sets the interest rate. Currently, it’s set at 2%. If the RBA decides to increase interest rates, it is likely your mortgage will also increase, although on the upside, so will term deposit rates; equally, if the RBA drops interest rates, your mortgage repayments will drop—but so too will interest earned from your term deposits.

Like the RBA, the central reserve banks in other countries use interest rates to stimulate or slow their economies. In simple terms, they drop interest rates to stimulate economic activity when things get too ‘hot’, and they increase interest rates to cool them down. Oftentimes, though, the reaction times are a little too slow, which causes things to go off the rails, resulting in the boom-bust cycle continuing ad nauseum.

Now, consider what would happen here if RBA interest rates became negative. What would be the impact on cash in the bank, lending, and other areas of the economy?

Today, Japan, Sweden, Switzerland, and the Euro zone all have negative interest rates (to varying degrees).

If you placed your money into a bank account in Europe right now, it’s highly likely you would be actually charged interest for putting money in the bank. That’s right—you would not be earning interest; instead, you would be charged a fee for depositing the money! In the long term, of course, this really hurts savers and retirees.

Conversely, in some cases if you have a loan with a bank in Europe, the bank will pay your mortgage for having this debt drawn down. Other loans are simply dished out at a very low interest rate, such as 1–2% p.a. Naturally, this encourages people to take on debt at levels far greater than when interest rates are at normal levels.

You can see that very odd things start to happen in the long-term as this topsy-turvy situation plays out.

Other areas of the economy also become distorted. If there is a trade surplus position like Japan, which means they export more than they import, then negative interest rates could end up pushing the currency up against, say, the US dollar.

On the other hand, if there is a trade deficit, the currency can depreciate—like the British pound did against the US dollar. This all has to do with the need for funding and attracting overseas investment to fund the shortfall. In Australia, if we ever went negative, we would almost certainly suffer a similar fate to the UK.

The hope is that in the long term, these economies will normalise and interest rates will return to a more normal level. However, if the market continues to price in negative interest rates for Japan and Switzerland for at least the next 10 years, this phenomenon might be around longer than we think.

So, if you see some strange things happening abroad, remember it might relate to the negative interest rate environments these countries are currently enduring, and bear in mind that one day, their interest rates will likely normalise.

Please also remember that before embarking on any investment decision, you should always seek professional guidance from a licensed financial planner. Of course, I recommend AJ Financial Planning.

Interest Rates…Should I borrow more when they are high or low?

In 1976 the RBA (Reserve Bank of Australia) cash rate was around 12.85% and the average home loan back then was around 15.35% to 17% p.a.  Today some 38 years on, things are very different with the RBA cash rate at 2.5% and the average home loan is around 5%. Now in the past 10 years or so the RBA cash rate has not been as extreme. In reality they have floated between 7.25% and as low as just 2.5% more recently. The question I often here is “Should I borrow more when the interest rates are lower?”  You could buy things like a bigger home or an investment property, or use leverage for a business or an investment portfolio?  Another other option could be to focus more on paying down debt when interest rates are very low.  You can pay down debt a lot faster as the interest rate is not as high. Today, interest rates are incredibly low based on historical measures.  Regularly I see ads for 0% finance on a new car being purchased.  Credit card companies are offering interest free periods and to purchase an investment properties (depending on the yield as sometimes there can be variance) can be close to cash flow neutral if the deposit is large enough. Alternatively, it could be a time to think about renovating the home using debt, or buying a bigger house and borrow more as interest rates are so low.  It can be a very tempting time to go on a credit binge! So the questions becomes “Should I take advantage of all this cheap credit?”  The answer however like most questions in finance, is a little more challenging. In reality sometimes you want to be acting counter cyclical with the approach you take.  This idea is more common place with investing which goes something like this….. when everybody is running for the hills and not wanting to buy shares…you should be buying shares (assuming the asset is close to the bottom).  When everybody is going crazy for shares and there is a bubble you should be possibly thinking about selling. So how do you apply this idea to the interest rate questions?  Well most crashes generally are based on cheap credit, the lead up to the GFC people were using their homes and the equity in their properties as an ATM machine to buy stuff.  When the cheap credit stopped and the equity stalled everything, or in simplistic terms, it literally ground to a hault including consumer spending. So the answer to the above question comes back to the 2 following questions you might ask?

  1. What am I doing with the credit and what am I trying to buy?  If I apply a counter cyclical methodology I should really be asking myself is everybody running for the hills or jumping in thinking this is too good to be true?
  1. Can I afford this debt if interest rates rise on this debt to 8% or higher?  Today a 1% increase in interest rates would put 25% of the mortgaged population in mortgage stress, you want to make sure you are not in this sinking boat.

Like all difficult decisions it is important to do some complex financial modelling to work out which is the best way to go, and this is where we can help!  We can put together a blue print path for you, crunch all the numbers, and work out the best way for you to go. So if you would like to seek qualified Financial Planning assistance and we would recommend speaking with our team at AJ Financial Planning.