Where to with Interest Rates?

Written on the 1 October 2013 by Callum Scott

Interest rates are at a historic low.  Great news for prospective real estate buyers, whether they are investors or home buyers.  Lenders are increasingly competitive, with 73% of lenders offering loans that require a low deposit of 5% and less in some cases.  This figure stood at 49% in 2010 (research by RateCity).

Naturally, this is having an effect on house prices.  They are moving upwards, especially in NSW but elsewhere also.  Self-Managed Super Funds (SMSF) are contributing to this, given that individuals can now borrow to invest in property in a tax effective way.

This makes life hard for the Reserve Bank of Australia (RBA) who set the base rate that acts (usually) as the benchmark for interest rates charged by lenders.  However, their responsibility is for the Australian economy as a whole.  A reduction in interest rates can drive our dollar lower and thus make our exports cheaper, stimulating demand.  Business borrowing is cheaper and can stimulate business expansion.  This should feed through to an increase in business confidence, adding further stimulus.  All this boosts employment which, in turn, drives household confidence that should encourage spending and investment and feed back into the general economy.

The fly in the ointment for the RBA is the possible formation of a “housing bubble”.  In simple terms, this just means that house prices become unduly inflated because of a demand driven by overconfidence, exuberance and a belief that prices will continue to rise rapidly.  “Easy money” aka low interest rates, minimal deposits on borrowing and slacker borrowing criteria can exacerbate this.   And we know from experience, not just in housing, that bubbles eventually burst.  An overreaction can occur again, but this time on the downside with prices and demand plummeting.

Housing is critical to families.  If they see their home value and/or investment property value drop, they lose confidence, cut spending and generally spend less.  Naturally, this affects the overall economy.  A further current problem is what has been called the two-speed economy, where mining and related industries are doing much better than the rest.

The RBA therefore wants to stimulate the economy but without creating a bubble in house prices.  

So what do we have at the moment?
•Mining and related industries are still doing well.
•The remainder are somewhat sluggish.
•Unemployment rising.
•The dollar is still relatively high.
• Interest rates are at historic lows.
•House prices are rising and a there is a significant rise in real estate investment.
•Incidentally, the RBA is commenting robustly or, as they say, “jawboning” about the perils of speculation in the real estate market.

A further rate cut would help reduce the dollar, encouraging exports and consequent domestic production, encourage business borrowing and expansion, flowing into employment but this risks overstimulating house prices.  It’s a balancing act where the consequences of getting it wrong are profound when you look at what has happened in the past and elsewhere.

However, the modest rise in house prices that we are seeing hardly constitutes the formation of a bubble.  Prices are really just playing catch up after a period of stagnation.

If we get another interest rate cut, and there is a good chance of this, it will probably be the last for some time.

Dr Callum Scott

Author: Callum Scott
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