A light lunch could be the order of the day for tomorrow readers, as the Reserve Bank of Australia (RBA) prepares to announce its interest rate decision at 2.30pm on Tuesday afternoon.
But before that has even happened there was unadulterated delight from politicians and commentators alike as Wizard Home Loans announced that it would be reducing its mortgage interest rates regardless of what the RBA does.
Wizard chairman Mark Bouris told the media that “It’s a risk, but we are cutting rates now because the cost of funding our mortgages has fallen, irrespective of the cash rate, and it is only fair that we pass that saving on to our customers.”
Where is the Risk?
Does that really sound like a positive statement? Who is it a “risk” for? Well, Mr. Bouris is clearly talking about it being a risk for Wizard, but potentially in the medium term we could be looking at a risk for the whole economy. We don’t mean that Wizard’s actions will create a domino effect on the economy, but that the actions of the RBA have the potential to induce the very problems that it is supposed to be trying to prevent.
Let’s take a step back to the past. What were some of the things that created the recent collapse in credit markets? Put simply it was cheap credit with easy lending practices followed by a period of more expensive credit with easy lending practices, ending with the inability of corporates and individuals to service the debt and the inability of banks to find investors willing to give it money to lend.
However, the full extent of the problems with the credit markets hasn’t yet had the time to play itself out in the market. Given the time it would, but not yet.
Interestingly there seems to be an undercurrent of opinion that Australian finance markets have come through this unscathed. Even though this is plainly not the case: ANZ, NAB, Opes Prime, Tricom, ABC Learning, Babcock & Brown, Centro, Rams Home Loans, etc., are all evidence that Australia has not been let off lightly.
The Risk is to You!
So what does this have to do with you, and why should you be concerned? Well, right at this moment, the Australian economy appears to be nearing a standstill, with very minimal or no growth in the economy expected. Whether it will fall into a recession with negative growth is uncertain.
While this is happening, inflation continues to rise. In fact, based on recent statistics, the annual inflation rate is now running at over 5% with the RBA not expecting it to return to the 2-3% target band until 2010 at the earliest.
In other words the RBA is choosing to ignore one of its core responsibilities at the expense of another. Unfortunately, they are not mutually exclusive. Inflation cannot be ignored.
Pressing the Inflationary Pause Button
The likely impact of a reduction in interest rates may very well have a short-term desired effect of giving a boost to the economy by easing debt obligations for consumers and business. In reality, all it is likely to do is delay the negative impact.
What the RBA should be doing is encouraging consumers and business to pay down debt levels which paradoxically they tend to do when interest rates are higher, because it becomes a greater burden. Yet when interest rates fall – the optimum time to be paying down debt – the reverse tends to happen, in that they tend to pay off less of the debt (largely because minimum repayment amounts are less) and in fact tend to expose themselves to a greater amount of debt as money becomes cheap again.
The effect is that although it may improve consumer and business spending and therefore assist with ‘growing’ the economy, it will have the consequence of applying further inflationary pressures, for example, by encouraging businesses to raise prices and therefore lead to a need to increase interest rates again. Only this time, the debt burden will be even greater with a potentially greater impact on credit markets.
