How Not To Predict Rate Rises

Interest rates will always be…about where they are now, and it’s misleading to suggest otherwise, writes Ian McAuley

Early in the campaign Tony Abbott recycled the line we heard so many times in 2007: “interest rates will always be higher under Labor”. The surprisingly low consumer price index (CPI) released on Wednesday has quelled that claim.

In fact it is specious for anyone to suggest that interest rates can be predicted on the basis of a government’s fiscal policy. Those who passed Economics 101 would probably have learned that loose fiscal policy — as indicated by the size of the budget deficit — leads to high inflation which in turn leads to high interest rates, but that economic abstraction has been trumped by reality.

When we look at the 42 countries on which The Economist reports economic data, we find no relationship at all between interest rates and countries’ budget deficits. In fact, some countries with huge deficits, such as the UK, USA, Spain and Greece, have very low interest rates.  These countries were hit hard by the financial crisis, and are using a combination of loose fiscal and loose monetary policy to try to stimulate their sluggish economies. Not an enviable situation.

Australia is fortunate in having escaped the worst of the financial crisis. Credit is due in several areas. Yes, we have the luck of commodities, for now, at least. And yes, the Howard Government did leave a very low government debt. And yes, Australia’s response to the crisis was well-managed, as testified by economists such as Joseph Stiglitz and even by the IMF. True, there has indeed been some waste. For example, had the school building program been spread over several years, it could have been done better.

But such waste is trivial when compared with the waste when labour and capital are left idle because a government is terrified of going into debt. Unemployment is a high cost to pay for an abstract dogma.

Because we have come through the crisis largely unscathed, we have not had to resort to panic-level monetary policy. Australia’s housing interest rates are at about the level they have been for the last ten years, during the terms of both the Howard and Rudd/Gillard governments.

One may observe, however, that interest rates rise and fall with inflation: that’s why some in the Coalition were hoping for a high CPI on Wednesday.

Our housing rates peaked at 9.6 per cent in August 2008 just before the financial crisis hit. Also, at that time, inflation was running at 5.0 per cent, well above the comfort zone of two to three per cent. It’s important to note, however, is that what counts in terms of the burden on borrowers is the real interest rate.  That is, the interest rate after inflation is taken into account.

Provided wages rise with inflation the inflationary component of interest payments is eroded by those wage rises. If one is paying interest at 9.6 per cent (known as the nominal rate), but is enjoying a 5.0 per cent wage rise, the effective rate, or the real rate, is only 4.6 per cent. In simple mathematics, the real interest rate is the nominal rate (as posted by the banks) minus inflation.

While inflation and therefore nominal rates have moved up and down, our real housing interest rates have been comparatively stable for many years – hovering around five percent. (They are now about 4.2 per cent.)

It is patronising for any politicians to throw around figures based on nominal rates, for on their own they are meaningless unless they are placed in the context of inflation. We are enjoying the benefits of an independent Reserve Bank – a reform initiated by former Treasurer Peter Costello – which gives us a stable nominal rate regime. If the Coalition wants bragging rights, that is where credit should go. By contrast, Abbott’s claim that interest rates will always be higher under Labor are grossly irresponsible.