There is a difference between the prevailing rates of interest in the money and credit markets and what can be loosely called the natural rate of interest. When the rates diverge, problems emerge.
The central bank in Australia (the RBA) conducts the management of monetary policy, independently of the Government of the day but to a stated aim of constraining inflation between 2% – 3%pa. It has just manipulated down market interest rates twice in two months. Prior to that, the official cash rate (the benchmark the RBA uses to influence all other rates) was held ‘at emergency low levels’ for 3 years. If the old rates were at emergency levels, then what are they now being lower still? The official cash rate is now 1%pa.
The natural rate of interest has no observable market, but it can be inferred. It represents the rate that lenders and borrowers would trade at in the absence of central bank manipulation of markets. Higher rates attract more savings to be made available but discourage more borrowings.
If the market rate falls below the natural rate, then savers are discouraged from lending yet lenders are encouraged to borrow. There is a shortfall of resources available to fund investment. This will be both inflationary and lead to lower quality investments. How is it possible that the RBA thinks policy adjustments that will constrain investment are desirable whenever the economy is showing signs of needing new investment to the capital stock to keep prosperity up? Is it putting its target inflation rate above all other priorities? Artificially lowering market rates is detrimental to the quality of investments undertaken. When interest rates are high, borrowers have to be much more diligent in the selection and management of projects. They must make a good return. The reverse is therefore true when interest rates are low.
The higher demand for credit, which is not backed up by a higher supply of savings, will manifest itself in an asset price bubble. Already, news reports of a rebound in housing prices are emerging. New investment is not possible if new savings are not made available. The demand for credit ends up chasing assets already in the productive stock. Boosted asset prices for real property and existing financial assets are not in the interests of the country. The RBA should have never lowered market rates to the emergency low levels we got to 3 years ago. Then, the RBA should not have maintained those rates for 3 years. Finally, the RBA should not have cut them further. What the economy needs is relief from RBA interference to let the natural rate of interest establish its market signal. Interest rates must go up, not down. That would boost investment, add to the productive capacity of the economy and take some pressure out of overheated asset prices.