The Dangers of a Steady Low Cash Rate Approach

The Reserve Bank of Australia (RBA) has gradually lowered cash rate since 1990. The last significant upward cycle took off in the early 2000’s but was drastically cut short in the wake of the 2008 Global Financial Crisis (GFC). However, as the global economy bottomed down in 2009, and Australia witnessed its largest mining boom in recent history, in November 2011 the RBA started to gradually cut the official cash rate to its current record low of 1.5%. While this has a series of diverse effects in the overall economy, more significant implications are seen in the unemployment, consumption, corporate investment and housing markets.

The current low cash rate strategy has created a short term ‘safety-stability-net’ for the Australian economy which helped the economy to remain relatively stable while other global economies suffered significant consequences of the Global Financial Crisis (GFC). However it is uncertain if this strategy is sustainable and raises concerns of its long term effects, which may not be positive for the economy.

While maintaining low rates has helped the Australian economic stability, it could, in the long term, have negative implications. Some of these include increasing risky debt, speculative bubbles, leakages from foreign investments, the risk of not being able to increase interests without significant economic consequences; and inequity, reducing the quality of life for the less wealthy and favouring the richest. In the long run, these implications may have other economic consequences such as the need for additional government subsidies, further leakages, high crime rate and recession.

Cash rate

The Reserve Bank of Australia (RBA) sets the target ‘cash rate’, which is the market interest rate on overnight funds. Target ‘cash rate’ are one-day loans that help banks keep each other liquid. This cash rate is a key instrument for monetary policy used to stimulate the economy on the desired direction. The RBA dropped the cash rate to 1.5% in August 2016 and has remained at that level. The drop in cash rate has been done in response to the losses in the mining industry and to diversify the economy.

The cash rates have different effects, if they go up lenders would want to increase demand on overnight loans as they would get more revenue from them; the effect would be a decrease in supply of long-term loans, which potentially would result on interest increase for other types of loans, including mortgages. When interest rates go down, borrowing becomes cheaper so there is an increase in supply of long-term loans at lower rates, including home loans. Therefore, a lower cash rate incentivises low interests in long-term loans and with this investment, consumption, production and employment increases.

The RBA took on a more aggressive ‘cash rate strategy’ since 2012 when the mining industry took a decline. RBA aimed to maintain inflation within a 2% to 3% range. Through the low cash rate strategy, RBA aims to stimulate and achieve a diversification of the economy. The rationale behind the strategy, is that savings for banks ‘pass on’ to consumers.

While interest rates are low, investment grows and consumers have more liquidity to spend in the economy; also, as interests on savings are also low there is less incentive to save. Based on the circular flow model, savings are considered a leakage whereas investment is an injection so low cash rates seems to be the perfect formula to keep a healthy economy while supporting diversification.

Price elasticity of demand and the Australian housing prices

Due to the price elasticity of demand, as long term loans like mortgages became more affordable, demand on housing increased, however as the supply was less than the demand, this led to a significant increase of housing prices in most Australian cities.

The mix of high demand, low debt cost and low supply stimulated growth of residential construction with a rise in real estate investment. As a result, RBA was able to meet its short term desired target of increasing employment and consumption in the country.

However, this approach has a side effect attached as well. While the rise in housing prices has been a greatly profitable business for constructors, prices have risen so much that housing has become unaffordable for the consumers.Hence, individuals who are not in the investment game find it difficult to compete against investors when trying to buy a home to live in.

Debt levels on the rise

Marion Kohler and Michelle van der Merwe (2015) explained how the housing prices have increased consistently with a 5 % average inflation rate in the past decade. The main concern here is that housing debt-to-income ratio has increased as well (see chart 1 in appendix) and if interest rates go up or tax benefits are reduced the debtors in the population may not be able to afford their mortgages and this could result in a recession.

Another consideration is that housing prices continue to rise at a significant rate, faster than consumers’ incomes. While benefits and tax exemptions seem to help investors, there are little benefits to alleviate home owner’s consumption pattern.

Analysts have expressed concerns that the Australian house prices to income ratios are showing similar trends to those observed in economies prior to speculative bubbles to burst. Current housing prices to income ratio in Australia is close and in some cities even higher than the levels this ratio presented in the U.S. before its two biggest recessions in 1929 and 2007 (see charts 2 and 3 in appendix).

The risks of oversupply

In early November 2016 the RBA announced that despite the housing supply hasn’t reached equilibrium with demand in major Australian cities yet, if construction continues to grow at current rates there will be an oversupply in the CBDs of some capital cities in the next 5 years.

It is important to note also that Australian population growth rate of 1.3 - 1.4% per year (Australian Bureau of Statistics, 2016) is significantly slower than current dwelling construction rates of 2.5% (IBIS industry report, 2016) which can possibly reach a point of saturation in the next 5 years (see chart 4 in appendix).

Another consideration is the type of dwellings that are currently being built. Majority of the investment is going towards apartment blocks in the inner city of major CBDs, however, this is not necessarily the type of housing the Australian consumers are looking for. Young families prefer houses with backyards in the suburbs rather than crowded apartments.

This trend has already been seen in Melbourne where a great percentage (around 20%) of new rental apartments are vacant even after a year of completion. Some analysts believe that the government is somehow subsidising these losses with ‘capital gains’ and ‘negative gearing’ and this has become a dangerous game as these benefits can possibly be more powerful than the rental income.

Cash rate effects on savings

While low cash rates stimulate debt they also discourage savings. As expenditure goes up, savings go down. Interest return on savings is so small that money remains injected in the economy instead of leaking into consumers savings.

This, apparently is a significant result of the low cash rate strategy; however it also has a direct effect on housing affordability for consumers and an immediate effect for the oldest population.

Low interest rates have made it difficult for consumers to save for a house deposit which continue to increase as the house prices go up. It can be said that low interest rates and its potential consequences have reduced the possibilities for consumers to own a home. There is only a small proportion that can safely afford housing at today’s rates, borrowing 80% or less of the property value as recommended by the RBA. In the long run, low interest rates is building an economy in which the rich investors are vastly benefited and the consumers are destined to pay rent all their lives or have to take huge debt to afford a house.

Despite numerous regulations which intend to prevent risky debt, it is important to notice that banks are lending huge amounts of money through mortgages. If this trend continues, it is most likely that construction will reach a point of saturation in the next 5 years. The saturation in the construction and housing market may come with side-effects such as the possibility of high unemployment. Moreover, lending at today’s rates cannot guarantee buyers will always be able to afford their debt if interest rise again which can be a strong threat to the economy on the whole.

It seems that a population without savings wouldn’t be prepared to respond to a recession or to afford their mortgage payments in the case of unemployment.

Inflation

The RBA creates monetary policy to control inflation within a target range they consider ideal for the economy, currently defined between 2-3%. This rate of inflation is sufficiently low that it so it does not materially distort economic decisions in the community, but as it is always above zero it indicates that prices always go up incentivising consumers to “buy now before things become more expensive”.

As inflation goes up Aggregate Demand (AD) also goes up. The RBA argues that if inflation was too low, consumers would tend to save more and spend less and this would create a contraction effect in the economy that could eventually drive to a recession. It is important to notice that while current inflation is lower to the desired rate (1.3%), trust in the economy remains strong, and as stimulus in consumer savings are so low this contraction effect is unlikely to take place at this point.

As discussed previously, as per the demand pull inflation while demand for housing increases, prices climb; and property becomes an excellent opportunity for investors. However, this type of inflation can have a negative effect on consumers. Investors have also multiplied, from a local and foreign background. In an economy where there are many wealthy investors who have benefited of the reduced rates and tax benefits spend in the economy, there is an increase in demand in local and imported products, which increasing as a result demand, and with it the prices of the entire economy, moving into a wage-price spiral.

On the other hand, with constant inflation there is a constant currency devaluation, this favours Australian exports as they are cheaper for overseas buyers and also stimulates foreign investment; including real estate investors and constructors, who spend significant amounts of money in the local market favouring the price rise for dwellings.

Unemployment

The Phillips curve states that unemployment and inflation are inversely related: as levels of unemployment decrease, inflation increases. The relationship, however, is not linear. Graphically, the short-run Phillips curve traces L-shape, when the unemployment rate is on the x-axis and the inflation rate is on the y-axis.

In Australia, currently inflation is lower than the desired range (1.3%) and we can see the unemployment rates are low but have increased in the past years, remaining between 5 to 7%, averaging 6.93% from 1978 until 2016, being the highest rate in October 2015 and lowest in February 2008. If inflation remains in the desired range (2-3%) it is expected that unemployment remains between 5-7%.

Maintaining unemployment rates under control so that the government can ensure the economy is active, consumption keeps moving and the government payments for unemployment is maintained under control.

Based on the Australian Bureau of Statistics report from August 2016, we can see that, consistently with the Phillips curve the Australian economy has followed a trend while inflation has gone down, unemployment has gone up (see charts 5 and 6 in appendix). Despite both inflation and unemployment have remained under 10%, some analysts have raised concerns that in the case of a speculative bubble burst and a recession, unemployment will rise and inflation would go down, this could have disastrous consequences affecting consumption, the local economy and the exports.

Speculative Bubbles

As property price to income ratio has increased its current high levels, some analysts believe this is a symptom that the Australian property market is in a speculative bubble which could burst in the next couple of years.

One of the arguments behind this prediction is that it seems the current property prices are more driven for who can pay more for them than their real value, and how much could be the future financial benefit to them. Property auctions in the main cities, on the other hand, has allowed that some properties are sold to investors at prices which were not expected. It is reported that foreign investors find it reasonable to invest in Australia despite the high rise in housing prices.

It is important, that the RBA keeps monitoring these anomalies and ensure it puts measures in place to avoid these skyrocketing prices to continue. This is in order to prevent the bubble to continue to inflate and eventually burst, which would generate a recession and damage the current economic stability. It is also important to keep into consideration prudential regulations for lenders so they ensure that buyers can afford their debts if interest rates increase in the future.

Economic Inequality

Dr Anne Holmes (2015) defines economic inequality as the unequal access to wealth and income and how as this mostly refers to income, in most developed countries like Australia, market income is mainly from wages and salaries, but also from returns on capital such as shares and rents. It is concerning how the cash rate strategy, along with the negative gearing have favoured real estate investors to a point that most recent statistics have starting to show entire suburbs in the main capital cities where more than 50% of the units are investment properties, and this number continues to increase.

The Reserve Bank Board sets interest rates so as to achieve the objectives set out in the Reserve Bank Act 1959, these include the stability of the currency of Australia; the maintenance of full employment in Australia; and the economic prosperity and welfare of the people of Australia.

The current monetary policy is achieving all these objectives however, the growing inequality is putting consumers in disadvantage and the economy at risk, it is incentivising heavily investment but making it hard for consumers to acquire homes, and those that do are acquiring enormous amounts of long term debt which are risky if interests go up. On the other hand, the increase in investment properties will favour a high supply of rental properties which will destabilise the rental market, however the current generation of consumers who can’t afford owning a home will be destined to rent, and eventually will become a generation the government will need to subsidise.

The Cons

We have seen how the low cash rate strategy has helped maintain economic stability and growth but also how it has a series of compromises in the overall economy and the opportunity cost seem to be a problem for the long term future of nation.

While low cash rate benefits investors and stimulates the expenditure in the economy, this is also stimulating debt and discourages savings. Low interests in savings affect directly a vulnerable group of the society; retirees who depend on their savings to live; as well as younger generations who can’t save for a deposit, therefore can’t afford to buy a house, plus the fact both groups are taking enormous risks and debt to acquire properties or investments. The long term effects of this could be negative for the economy, both demographic groups would require further support from the government in the coming years, will probably need additional subsidies to live and maintain a decent quality of life when they become less productive.

There is also the growing disparity in the society where, investors receive the benefits and become richer and those who can’t afford entering the investment game have no benefits, find it hard to own a place and eventually become poorer. This also means that rich people are who are more likely to save and if the economy fails, they can more easily move their wealth to other markets that are more profitable.

The trap

There are many things that at this point could hurt the economy and it seems it has been set in a position where there is no much possibility to make changes without having huge effects.

If new housing construction reaches a saturation point and declines, both investors and employment will suffer, and with them, the economy. If on the other hand, interests rise, the investors will “cost push the inflation” to the tenants and rents will become expensive, which could affect housing, consumption and in an economy where consumers can’t afford owning their home, the economy will shrink. For those that have bought, higher interest mean less disposable income to spend in consumption which has the same effect.

If on the other hand, the government removed the current tax benefits for investors, this would have a similar effect, the costs will pass on the consumers or tenants, plus their investments would go into other markets that are more profitable.

In the long term it seems the measures to keep the economy stable have put it ratheron a fragile place where any move will have it’s compromises and the space for moving is minimal, pricings are so high that lower them would mean losses for current owners and investors, interest are so low that increasing them would hurt them as well; and the economy is mainly supported by mortgages to a point that in the case of a recession or bubble-burst the consequences would be catastrophic.

Unfortunately after this analysis it seems that we can conclude that the measures that started with the search for diversification of the economy and moving it away from its dependency on the mining industry, have moved the economy into a dependency on the housing industry, however the risks associated with this, seem to be the same or worse than they were when dependency was on the mining industry in the first place.

Getting out of the trap

As discussed before the strategy of the RBA has some long term risks for the economy and the welfare of Australian citizens; however there are some measures that could be taken in order to prevent the economy from failing.

If monetary policy can only be used to achieve one only objective at the time and considering that keeping inflation between 2-3% since 1990 has helped keeping the economy stable; but the main risks of this strategy are its long term effects. An improved monetary policy should now focus on the domestic economy, currently at risk.

It should work along with fiscal policy to reduce the dependence of the economy on the mortgage industry, currently exposing the economy to a potential recession or a bubble burst, in other words should aim to deflate the bubble while maintaining healthy investment levels and consumption and the quality of life of the consumers.

Get help in Any Subject

Our intention is to help numerous students worldwide through effective and accurate work.

 

The new monetary bubble should keep the goal of reduced inflation, but ensure it provides restrictions to the banking system on the lending risks they take, and discouraging the growth of investment at the costs of the consumer's quality of life.

Some recommendations would include;

The banks: Maintaining a low cash rate (between 1.5% and 3%) but limiting the amount that local banks can borrow from foreign banks, to limit the effect on the case of a foreign crisis. Implement a minimum reserve for banks and reinforce regulations to ensure they only lend to qualified consumers that could afford an increase in interests in the future. Offer stimulus for banks to offer savings benefits to consumers that are in disadvantage like pensioners that live from their savings or aspiring homeowners that need to save for a deposit. Incentivise early debt payment.

The investors: Increment barriers for foreign investors and facilitate local investment so leakage is reduced. Continue to incentivise the housing construction, but ensuring it is the quality the market is demanding and not the current one that is saturating.

Housing prices: Re-look at the auction system and regulate housing prices; looking at an approach of set prices per square meter depending on location instead.

The affordability: Implement regulations to ensure salaries growth is aligned with inflation. Create benefits not only for investors but also for consumers /homeowners

Diversification: Provide stimulus to other industries to really diversify the economy, support internal production or services. Put higher barriers and taxes to imports to incentivise local production.

The population: Incentivise natural growth of the population so consumption can naturally increase as inflation increases (currently 1.4%). Educate the population on basic economics and investment, teach the local citizens to take advantage of their money and help them to keep moving the economy.

Long term benefit housing: Offer benefits to organisations that want to support making housing affordable for consumers, not only investors. And building the type of housing that improves the quality of life of new families, incentivising natural population growth.

Despite monetary policy can only affect one thing it can work in conjunction with fiscal policy and small adjustments in different areas can provide a safer environment for investors and local consumers; as the economy is at a very sensitive point the measures should be taken from an overall perspective, to ensure all possible implications have been considered and with them preventive measures implemented.

References

  • Samuelson, W. & Marks, S., 2014, Managerial Economics, 8th edition, Wiley.
  • Marion Kohler and Michelle van der Merwe, 2015, Long-run Trends in Housing Price Growth.
  • Dr Anne Holmes p.44, 2015, some economic effects of the inequality, Parliament of Australia.
  • Tim Lawless, 2014, National Market, Research Blog Industry Analysis
  • Rocio Sanchez-Moyano, 2013, How Helpful is the Price-to-Income Ratio in Flagging Bubbles? Harvard Joint Center for Housing Studies
  • IBISWorld Report. House and Construction in Australia, November 2016.

Back To Top

Captcha
Exciting Deals & offers on our AppInstall Now
Please Select Your Location to Serve You Better
Request Call Back
Request Call Back