Low Official Interest Rates
The Reserve Bank of Australia has cut the official interest rate for cash deposits to record low levels but what does that really mean for investors and the Australian economy generally?
People are now very careful to say “official” interest rates because there is absolutely no guarantee of whether or to what degree the Australian banks and other financial institutions will pass on any cut in official interest rates to the people and parties who deal with and borrow from them.
The current official rate of 1.75% is an historic low for interest rates in Australia but whether these low rates are sustainable or more significantly ought to be sustained in the medium to longer term is far from certain.
Many years ago it one of my responsibilities was to look after the private placement (sale) of AUD denominated debt securities into the professional Japanese market. One of my main contacts there managed the fixed interest desk at a major Japanese life insurance company.
He told me that to effectively break even, that institution needed to earn an average rate of return on funds of at least 3.50% per annum. If official rates were pushed to levels that made that return rate commercially unachievable, then the company could still survive but at some ongoing cost. Effectively an institution in that position was forced to live by consuming its own financial reserves and resources until such time as financial markets recovered and the interest rates on offer rose above its break-even rate of return.
That experience when applied across an economy illustrates the truism that when official rates are set at a level below the break-even point for the operation of major financial institutions, they come at a real economic cost. If the low levels of interest rates continue for an extended period, they have the power, by progressively weakening the major financial institutions, to sap the strength of the underlying economy and financial system. The present state of the Japanese economy, its financial institutions and system is a prime example.
So when it comes to Australia’s present low level of official interest rates it is better to think of them as being good in the short term to promote recovery but potentially harmful if continued into the long term.
