Should You Want Interest Rates to Fall?
Following a period of high inflation, central banks tried to undo years of monetary stimulus by raising interest rates. The Reserve Bank of Australia started with a 0.25% increase in May 2022. This was the first of 10 consecutive monthly increases, including four 0.50% increases. After a pause in April 2023, the Bank raised rates three more times for the year: 0.25% in each of May, June and November. Inflation remains well above the target range (in the September quarter of 2023 the inflation rate in Australia was 5.4%). Despite this, 2024 begins with talk of interest rate cuts.
While the immediate reaction to such a prospect may be positive among those with high mortgages or those hoping to borrow, it is worth pausing for a moment to consider whether a cut to interest rates is a curse disguised as a blessing.
The key point is whether a lowering of interest rates is artificial rather than natural. Economists use the term “natural rate of interest” to refer to the rate of interest that would prevail if there was no intervention to increase or decrease it.
The market system determines a natural rate of interest based on people’s time preference (patience/impatience) and the productivity of roundabout production methods. While we speak of interest in monetary terms, it is better to think in real terms. Interest is the difference in value between the oak saplings planted now and the timber harvested many decades hence. This value will be higher if people are more impatient and lower if they are more patient.
Interest is the reward for waiting. Also, if you postpone consumption and build a better production method, you can typically produce more. For example, instead of picking berries by hand, you save some berries, then take a day off from picking to build a little contraption that allows you to pick more berries. The increase in berries is a reward for your patience and an example of how more complex production processes are more productive.
When people are patient, they save. Savings build up, lowering the (natural) interest rate, and giving entrepreneurs access to the capital they need and the indication that people are generally in favour of roundabout production processes. They are willing to wait. When people are impatient, they borrow and spend. Savings decline. Debt builds up. Interest rates rise. Entrepreneurs find credit hard to get and they get the message that people aren’t interested in waiting for a new production process to be built.
Central banks can artificially increase or decrease the interest rate. They do this by pulling money out of the system (increasing rates) or pumping money in (decreasing rates). If interest rates would otherwise tend to remain where they are or increase, setting a lower rate of interest will require money to be printed and pushed into the economy. Should you want this to happen?
This question depends very much on whether you will be one of the winners or the losers. And whether you are a winner or a loser in this game may not be entirely clear for quite a while. You might be both. Your house price and stock portfolio might go up, but your purchasing power at the supermarket goes down. Your ability to borrow might increase, but the price of the house you want to buy goes up. Your mortgage payments go down, but so does the interest you can earn on your savings. The nation’s wealth (measured by the dollar value of assets) increases, but the increase mainly goes to those who held assets at the right time.
It is best to consider very carefully as much of the game as possible before coming down in favour (or against) a particular move. Here are some things that people usually overlook:
- A positive inflation rate, even one that is falling from some higher level, means that prices are still rising but at a decreasing rate (disinflation). If inflation was 5.4% in 2023, say, and falls to 3% in 2024, that means that all the price rises you experienced at the supermarket are still in place. They’re just not increasing as fast. Prices haven’t decreased until inflation turns negative (deflation).
- Productivity can reduce inflation, helping alleviate the effect of higher interest rates. Policies that are favourable to business and production and worker output per hour will add goods to the economy that help soak up the money that was printed during a period of artificially lower interest rates. Policies that reduce the price of key inputs, especially energy, have a similar deflationary effect.
- Much can depend on the exchange rate. The inflation rate in the United States has fallen considerably from 40-year highs (though prices are still rising). A large part of this can be attributed to strong demand for the US dollar during 2023. If the Australian dollar rises, imports become cheaper, lowering prices for some consumer items.
- Investments in tangible things like houses help insulate you from inflation but the dollar value increases in your net worth are mostly not matched by equal increases in purchasing power. For example, $200,000 in 2004 is equivalent in purchasing power to $315,000 in 2022. If your house went from $200,000 to $600,000 during this time, your paper wealth increased by 3x but your actual purchasing power only 2x. Compounding makes this worse and worse over time. For example, you might have paid $40,000 for a house in 1970. Today, it might be worth $1,000,000. That’s an increase of 24x. However, $40,000 in 1970 buys you the same amount of goods as $520,000 today. Your real purchasing power only went 2x.
- The numbers we just discussed are based on official inflation measurements. The consumer price index (CPI) may or may not reflect the true impact of inflation on you. Your grocery bill might have increased by 20% even though the official inflation number is 5%. The differential between nominal and real wealth we worked out might be even worse. That is, your house might have gone 24x but your real purchasing power, depending on where you are and what you buy, might not have increased at all.
- Even at low levels, inflation erodes your purchasing power considerably as time goes by. For example, if inflation is just 3% p.a., the value of $1 will fall to 40 cents over a period less than your working life (30 years). After 40 years, it will be worth just 29 cents. If the inflation rate is higher, say, 5%, your $1 is worth 35 cents after just 20 years.
- Since 1960, Australia’s inflation rate has averaged 4.7% p.a. If you put $1 in a savings account in Australia in 1960, that $1 would buy you just 5 cents worth of goods in 2023. You can see how inflation acts as a headwind for all those people who just can’t get hold of some tangible assets. Every year that passes, they get further behind. It is quite ironic that governments and central banks are often called upon to do something to remedy this situation, since some would argue that most of the decline in purchasing power was caused by central bank profligacy in the first place. Whatever the case may be, governments and central banks could do wonders for wealth equality by maintaining the purchasing power of the dollar.
Should you want lower interest rates? It depends on whether lower rates are artificial or market-driven. Artificially lower rates are inflationary. Once inflation gets going, its effect on you is a matter of what your current asset position is. Big picture, it is worth noting that inflation has accompanied many of the world’s most tumultuous periods of political instability over the past 300 years.