Are interest rates unnaturally low? Or are they where they should be?
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.
by Tim Farrelly, CEO of Farrelly’s, and asset allocation consultant to Australian Unity Personal Financial Services
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