Interest Rates

While a few have flexible rate mortgages, most households in New Zealand hold fixed-term mortgages with a one or two-year term. As these fixed-term mortgages have been coming due for renewal, the cost of higher interest rates has begun to bite, and households are feeling the pain. Most are hoping that interest rates will fall quickly.

I believe that is a false hope. The problem is that the low interest rates that prevailed for most of the twenty-first century were abnormal. Following the global financial crisis, the US Federal Reserve pushed interest rates low and kept them at that level for the following decade.

Modern central banks manipulate interest rates to control the supply of money in the economy. Keeping interest rates near-zero for so long would normally significantly increase the supply of money and cause massive inflation. That did not happen for two reasons. Firstly, most of the additional money flowed into the share market, causing a massive increase in share prices (some also flowed into the commercial property market). This was inflation contained in a financial asset market, so most people perceived that to be good.

Secondly, during the first two decades of this century, Western nations started importing most of their consumer goods from China and other parts of Asia. Due to production efficiencies, the prices of consumer durables and vehicles dropped massively. So, the inflationary effect of low interest rates was cancelled out by the effect of cheaper imports from China. In this context, the inflationary policies of central banks benefitted richer people who owned financial assets while not harming poorer people because they had access to cheaper consumer goods.

Unfortunately, this situation will not continue. If central banks reduce interest rates significantly, the increase in the supply of money will cause inflation. If financial markets lose confidence, excess money will not be able to flow into financial asset inflation as it did previously, so it will tend to move into consumer inflation. The Chinese will not come to the rescue with cheaper goods, because their incomes are rising and because the United States is deliberately trying to reduce dependence on Chinese imports.

If central banks reduce interest rates too far, they will create a problem with inflation and will have to raise interest rates again, to compensate.

Exacerbating this problem, the United States is running massive fiscal deficits, nearly a trillion dollars per year. That money has to be raised with borrowing. China is becoming less enthusiastic about holding US Treasury debt because it no longer needs to push its currency down to support its exports, so it will require high interest rates to compensate for the risks of holding US Debt. The need for the US Treasury to borrow to cover big fiscal deficits will require it to keep offering high interest rates on Treasury bills and bonds. These high interest rates will nullify the attempts of the Federal Reserve to reduce interest rates.

People hoping for a significant reduction in mortgage interest rates should understand that the low interest rates that prevailed during the 2010s were abnormal. In the current situation mortgage interest rates will go back to normal, which is significantly higher than the abnormal low rates that many assumed were normal.

My father bought a farm in 1946. He took over a mortgage on the farm held by an insurance company. The interest rate was 6 percent. It remained at 6 percent for the next thirty years. This is probably a more normal level for mortgage interest rate than what prevailed during the 2010s. That is probably the normal that we will go back to in New Zealand. If governments in the western world keep increasing their debt, rates may need to go higher than that.

Controlling Interest Rates

During the middle ages, the church attempt to set the just price for bread. Their efforts failed, because they either set the price too high and created a glut or set it too low and created shortages. They eventually gave up.

Governments used to control prices from time to time, but have now given up for the same reason. The last bastion of price control is the interest rate. Most governments still attempt to control the interest rate.

The interest rate is the most important price in the economy. It is the price of the future. It should reflect the value that people place on the future. If people have confidence in the future, they will not need much compensation for saving, so interest rates will be low. On the other hand, if people have no hope for the future, the interest rates will be high. A future orientation will reduce interest rates; a present orientation will cause high interest rates.

Giving central banker’s control of this important price is a mistake. One problem is that they do not have enough information to get the price right. Most of the time, they set it too high or too low.

The other problem is that controlling the interest rate is a very blunt instrument. When using interest rates to slow the economy, central bankers hurt all businesses, not just those that are least efficient. Higher interest rates prevent efficient businesses from expanding and may cause some to shift overseas. Exporters are often hurt by the consequential rise in the currency. On the other hand, reducing interest rates to speed up the economy encourages all businesses to expand, when it would be better if only the more efficient ones grew. Worse still, the low interest rates can cause distortions in the economy, by encouraging speculation in fashionable assets.

Most of the time, central bankers are taking actions to fix up problems caused by their own mistakes. Allowing them to slow the entire the economy to eliminate a problem they have caused is like giving the key of your house to the pickpocket who stole your watch.

Artificially lower interest rates cause distortion in the economy. The housing boom was caused by central bankers setting the interest rate too low. A housing boom cannot cause inflation. If people become obsessed with owning houses, the price of houses will go up. However, those who are spending their money on houses will have to stop buying other things, so the demand for those things will fall. If the person buying the house borrows the money, the person that they borrow from has stopped buying something. A housing boom can only turn into inflation, if the government supports it by increasing the money in circulation. By setting interest rates very low after the Dotcom crash, the US Federal Reserve fed the property boom, turning it into a bubble that caused the Global Financial Crisis.