Deep T. Special: How low do Aussie interest rates have to go?

Official interest rates are heading negative everywhere that public and private debt levels are at record highs on every measure. Australia fits squarely at the top of the pile. No doubt influencing Australia’s central bank, the RBA, to reduce the official cash rate a further 25bps in August. Whilst predictable the explanation in the RBA minutes seems more confused than informed, more noise than signal.

Whilst the RBA seems to sweat on inflation, unemployment, income and growth numbers throwing in house prices, debt levels and what’s happening with the $A and in the rest of the world, so does every other central bank. Its central bank think. Figures like GDP, unemployment and inflation are constructed measures whose meaning is determined by the input, the algorithm and the interpretation. Things of beauty to any central bank bureaucrat and mostly weapons of obfuscation and deception.

This collective yet disciplined behaviour means that all central banks, no matter what narrative is portrayed ultimately do the same or similar things. It’s not a conspiracy but collective behaviour triggered by the same noise and motivations. But, behaviour is predictable if you look for the signals and remove the noise.

Forget central bank noise of manipulated statistical constructs, the signals for future interest rates are as follows:

  • Global GDP growth for a very long time has been driven by credit growth which under current settings is maxing for governments and households.
  • Much of the credit growth has been collateralised by non-productive assets which in turn have grown in value with the risk concentrated into 4 very similar banks in Australia
  • Australia’s 4 major banks are undercapitalised. They are not in the top quartile internationally. They are at best average and therefore vulnerable to capital flight.
  • Credit growth in both productive and non-productive assets creates new money and bank deposits, reduction in debt does the opposite
  • If there’s too much debt there’s too much money but almost by definition the debt and the deposits are in different and mostly generational hands, so the net of zero is irrelevant in assessing risk
  • Australia is locked into the trifecta of budgetary, trade and current account deficits, ensuring that the AAA credit rating will be lost and downgrades continue. The caveat here is that rating agencies are not consistent and act in self-interest. But more importantly, offshore borrowing needs to continue to grow to fund the deficits, so at least in the short term the rating agencies may be kind.
  • No central banker is going to deliberately crash asset prices to reset debt levels by causing losses on loans and a reduction of money in the system
  • Currency wars prevail around the globe with exchange rates set just as much on capital account as on the trading account.
  • Not to undermine the importance of the other signals but how about the fact that Australia has no means to pay back what it owes to the rest of the world ever, other than to sell the country, is some signal to be taken notice of and take action on.

Using that piece of wisdom that the herd will always act in immediate self-interest, the signals tell me that the politicians are not going to change deficit settings in any meaningful way so debt levels will not be reduced significantly, deliberately. Concentration of risk and liabilities means the markets overall do not want a crash and will avoid that by any means. Central bankers (CBs) will take notice of the signals whilst generally denying them and do the only thing they can, keep cutting interest rates into negative territory.

Whilst the CB meme will be that rate cuts are for stimulatory purposes in encouraging businesses to borrow to invest, this is noise and false. In an environment where the signals say structural risk and debt cycles are maximising but lowering interest rates increases asset prices, why is any business incentivised to take the risk to invest in productivity rather than assets?

To understand what will happen as risks in the system are cranked to breaking point we need to come at things from a different angle. Throw out traditional thinking. Perhaps the whole notion of principal and interest needs a bit of a rethink. Maybe a concept of risk capital should be built into the balance of each loan and deposit and repaid or not based on macro criteria, would make system management easier.

Negative interest rates are simply losses on capital over time whilst simultaneously increasing the real value or purchasing power of the currency unit. To put it another way, negative interest rates destroys the money that was over created by excess debt leaving the money remaining having a greater value per unit.  So rather than CBs lowering rates into negative territory to be stimulative, they’re destructive of volume yet value creative of the unit.

By lowering rates, driving credit growth and inflating asset prices, CBs have created an illusion of sovereign wealth creation when all they’ve done is rearrange the deck chairs on the Titanic. Creating excess money from unrepayable debt is a can kicking exercise of mammoth proportions but to the man in the street I suppose it seems like CB magic and for a time it feels great. It’s only as time marches does the realisation hit that its nothing more than screwing those left holding massive debts for the benefit of the privileged. All orchestrated by CBs and their political masters in order to look good.

That’s because the holders of excess debt (the victims) and excess deposits (the privileged) are in different hands and reducing both debt and deposits together is a political land mine. Whilst there’s a real sting in the tail most mortgage holders would be happy about repaying less than they borrow. Personal entitlement by the privileged screams that their deposits are untouchable. Negative rates are a way of making the pain more acceptable or more to the point, realigning investment in unproductive assets into a position where it’s more attractive to invest in productive assets.

Sounds like a pretty neat solution, but is it? Certainly explaining how we’ll be better off by making losses on capital is something of a challenge.

The questions that come to mind are; what level of negative rate will do the trick? How do you get there and what damage will the movement down do before things start to reset to the positive?

The movement of interest rates down into negative territory is necessary in the absence of a short term bust. However, it will drive asset prices up and this movement distorts investment decisions and incentives, but, it is likely to drive credit growth and therefore support CB statistical constructs that make them look good whilst actually making the problem worse. It’s only when the interest rates have unequivocally hit bottom that the rebalancing will take hold and reality bites. That bottom must be significantly negative. Zero or close just won’t cut it.

This is part one of a two part series on Australia’s future monetary policy options.

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