Interest rates, the good, the bad and the ugly

Interest is the cost of borrowing Money. The interest rate is calculated as a percentage of the outstanding loan for as long as the loan principal is not repaid in full. The rate of interest is generally based on the cost of Money to the bank or other lender plus a margin depending on the type and risk of the loan.

Interest is an interesting concept. As for any service or use of an asset to charge interest for the use of Money would seem a reasonable and good thing, even though some societies forbid the charging of interest. Interest is passive income that needs to be paid from active earnings and so the interest rate determines which party gets the best deal in that bargain.

The interest rate charged at any point in time has the same type of effects as the cost of any good or service. That is the higher the interest rate the less demand for borrowing Money or the amount of Money to be borrowed and created. This is a good thing as it allows for there to be a level of control over an economy that may need cooling or stimulating. Interest rates up, cooling. Interest rates down, stimulating.

Short term interest rates in Australia have been determined by the Central Bank since 1960. These short-term rates have a direct effect on interest rates offered to depositors and borrowers although banks are free to set any rate they like to any lender or borrower willing to take that rate.

On the surface having the Central Bank set interest rates can be seen as a good thing rather than allow politicians or the markets set interest rates.  In the Central Bank’s charter they have a “duty is to contribute to the stability of the currency, full employment, and the economic prosperity and welfare of the Australian people. It does this by conducting monetary policy (setting interest rates) to meet an agreed medium-term inflation target, working to maintain a strong financial system and efficient payments system, and issuing the nation’s banknotes”. No mention of Money creation powers which must be cause for questions on what the central bank defines as “monetary policy”.

Primarily, the Central Bank sets the overnight cash rate that banks can borrow from it. This in turn sets the interbank borrowing rate. These borrowing rates indirectly flow through to set interest rates for lending to citizens and businesses. So if the Central Bank wants to lower mortgage rates to encourage further borrowing for houses it simply lowers the overnight cash rate.

Encouraging borrowing through reducing interest rates has the result of encouraging Money creation which flows through to give the economy a boost. Of course, the reverse is the case, in that increasing interest rates would normally discourage borrowing and Money creation, putting dampeners on the economy. This simple tool when used effectively can lead to good results for the Central Bank in meeting its charter, but not always as we’ll see.

The Central Bank does not set longer term rates like the 3-, 5- or 10-year bond rates. Those rates are set in an auction process by the buyers of bonds. Buyers include superannuation funds, insurance companies and banks. The Central Bank has sometimes tried to interfere in the markets to set bond rates but this rarely works for the good. In response to COVID in 2020, the Central Bank not only lowered the short term cash rate but attempted to keep the 3 year at 0.10% pa until at least 2024. They failed miserably in this attempt as market conditions went against the Central Bank and the market took over setting the 3 year rate at around the 3% from 2022. Is it good or bad that the Central Bank can’t really control interest rates outside the short-term cash rate?

In setting the cash rate the Central Bank influences the mortgage rates. The cash rate is the interbank borrowing rate that determines the marginal cost of funds for Megabank but does not directly set the mortgage rate. Mortgage rates and deposit rates are set by each bank that makes up Megabank. Each bank under their terms can set the interest rates on mortgages and deposits to what ever they like. Competition within the parts of Megabank is meant to provide borrowers and depositors with the best rates. The bad news is that whilst competition provides some benefits, in the Australian system there are some bad consequences.

As defined Megabank is 80% four banks and competition can be hard to access and action at times due to the concentration of bank products. As stated, all parts of Megabank are not obligated to match the changes in the cash rate with equivalent changes in mortgage or deposit rates. On numerous occasions borrowers have been disadvantaged with the benefits of lower interest rates not passed on in full. Depositors have received the same treatment when interest rates rise. Megabank may be offering competitive low rates to new borrowers whilst having higher rates on the existing mortgage book for existing borrowers that make up most loan assets, definitely a bad thing.

Whilst this is unusual in a global setting, it’s how the Australian system works to the cost of citizens. Most countries have mortgage rates pegged to a benchmark rate set by their Central Bank or the market, or long-term fixed rates. Such interest rate setting protects borrowers from being taken advantage of by banks or other lenders seeking to boost profits by taking Money from citizens by over pricing of borrowers or under-pricing of deposits.

The American long-term fixed rate mortgage product is unique to the USA but it’s worthwhile looking as a contrast to our somewhat arbitrary interest rate setting system. American fixed rate mortgages have a term of 15, 20, 25 or 30 years with the rate set for that term at the start of the mortgage by reference to the long term government bond rate. But there is one very important additional term. American fixed rate mortgages can be repaid at any time without any cost to the borrower. For instance, if interest rates decrease a borrower can refinance their loan at a lower fixed rate without penalty that would be incurred under other types of fixed rate borrowings. Alternatively, if interest rates go up, the fixed rate borrower can sit on their lower fixed rate again without extra cost.

On any analysis, the American long term fixed rate mortgage is more equitable for citizen borrowers than the Australian system. Not only protecting borrowers from unscrupulous interest rate setting by banks but also from carrying a very large part of the burden of Central Bank interest rate increases. The American system keeps more Money in the hands of citizens. Should Australia look at this fixed rate mortgage system?

In the world of interest rates we’ve seen the good, some bad and now the ugly.

Interest is the cost of borrowing in the form of Money paid to the lender. For most citizens, a mortgage will be there largest borrowing and interest their largest expense. Interest must be paid monthly from the borrowers Money earnings.

The ugly comes from the Central Bank. When inflation gets into the economy, the Central bank uses its primary tool to try and slay that dragon, interest rates. When prices are rising faster than earnings causing citizens to have less Money, the Central Bank raises interest rates causing borrowers to pay even more Money in interest on their mortgages causing more monetary pain. To make this even more ugly, increasing interest rates are likely to lower the value of the house that secures the borrowing causing even more loss to citizens. In these circumstances, that we have encountered in 2023, citizens with mortgages on their homes lose more Money relatively than any other sections of the population. No more explanation is needed to understand why such borrowers that are a very important section of the population, get ugly about their dissatisfaction with the system and governments.

Ruled by the dogma to just increase interest rates across the board to manage inflation, the Central Bank just follows those rules without thought of where the Money is coming from and who pays. But government can do something about who wears the Money pain. Its worth noting that under the American fixed rate system borrower are not asked to bear the majority of the pain. There is no reason why Australia could not have our own version of long term fixed rate mortgages without penalty for early repayment.

The concept of interest seems simple enough but in the current era of low interest rates perhaps there is more to it. If we look at mortgage interest rates in terms of Money, what is interest, can look very different from the norm. The primary driver of housing is the cost of Money relative to earnings, or the amount of Money required to service the mortgage. Simply, the median house price is mostly determined by how much a bank would lend to a borrower on median income. The bank calculates serviceability, which is the percentage of the Money earnings of a borrower is needed to pay the interest and principal on the mortgage with an allowance for a modest increase in interest rates. So, for a certain amount of earnings, there’s a certain loan size and that is a primary driver of house prices.

For our average home buyer the house they can buy is adjusted for price by how much Money they can pay for principal and interest on the mortgage. If interest rates are cheaper, house prices or the principal is more expensive so the loan servicing is the same. For our house buying citizens what is principal and what is interest is irrelevant because they’ll spend the same Money for the same house regardless. Once the house is purchased though, when interest rates increase is when things can get ugly.

On the good side, since the early 1990s Australia has had a regime of decreasing interest rates with periods of relatively small increases and with periods of productivity increases and rising wages. Citizens able to take advantage of the interest rate decreases, earnings increases and the resultant increase in house values have and will receive significant real Money benefits. So who pays?

As we’ve seen in previous chapters just increasing the amount of Money does not maintain or increase its value unless its accompanied by increases in productivity. Increases in real Money to certain sections of citizens that gain that Money from increases in asset values and decreases in interest rates must result in decreases in real Money value to other sections of the population. The Money system including the external account with the rest of the world must always balance so if someone has a real Money benefit without productivity gains someone else pays for that.

From here it gets very ugly for many Australians due to a system that is inequitable and prejudiced. As interest rates are increased by the central bank due to inflationary pressures but with wage increases lagging, citizens that have purchased in the recent era of low interest rates are inequitably penalised. No one in a position to change the inequity cares at all as they follow traditional economic dogma regardless of who is punished. The prejudiced citizens have a higher cost of everyday expenses, a higher cost of housing through mortgage or rents and a likely a fall in house values. On the other hand, the 1%ers and those with Money savings benefit from higher interest rates and don’t take much load in the cost of interest rate rises. Remember, where there is a loan there is a Money deposit so it must be so.

This is very ugly for many and certainly inequitable. What is the most ugly is that the government and the central bank do not seem to understand the Money system and the effects of changes, or they chose not to. The Central Bank has other tools that it could use to cool inflation.

Interest rate increases effect the Money cost of loans and the Money income on deposits. Not exactly offsetting but mitigating any net effect of interest changes. The big driver is increasing or decreasing new borrowings by changing interest rates. Remember that loans create Money and therefore if interest rates increase, less borrowing is likely to occur reducing Money creation in the economy putting less pressure on inflation.

An alternate action to increasing interest rates would be for the Central Bank and APRA to work hand in hand to increase serviceability requirements for mortgage borrowers to reduce new mortgages rather than increase interest rates. Smaller interest rate increases together with loan serviceability increase would help to alleviate putting the cost of subduing inflation onto an innocent section of the population. That the Central Bank is not using this alternative measure shows its colours are very ugly indeed.

Rule 19: Interest is payable on borrowings to lenders. The Central Bank sets short term interest rates to cool or stimulate the economy in an independent fashion. Both good things. It’s bad that private banks can set interest rates on mortgage loans to any rate they like on any loan, at any time.  The real ugly is that the Central Bank can raise or lower short term interest rates causing harsh negative consequences for certain citizens when other tools are available that would have similar economic consequences but without the harsh penalties to borrowers or depositors.