The theoretical interest rate story goes something like this…
Lower interest rates encourage additional investment spending, which gives the economy a boost in times of slow economic growth. In Australia, the RBA is responsible for Australia’s monetary policy, which involves setting the interest rate on overnight loans in the money market (‘the cash rate’). The cash rate influences other interest rates in the economy, affecting the behaviour of borrowers and lenders, economic activity and ultimately the rate of inflation.
Changes in interest rates affect the public’s demand for goods and services and, thus, aggregate investment spending. A decrease in interest rates lowers the cost of borrowing, which encourages businesses to increase investment spending. Lower interest rates also give banks more incentive to lend to businesses and households, allowing them to spend more.
Over the last couple of weeks I have had client situations that have both proven and disproven the above theory, but not really in line with the traditional way of thinking.
Encouraging spending
I have done a great job conditioning clients to expect lower investment returns over the medium term. I have argued that getting 2.5% in a term deposit is not such a bad outcome at the moment, when you consider the risk to capital in most other areas.
Some clients are saying to themselves “if I am not getting any real return on my cash, why don’t I just spend it and enjoy myself?”. Theory proven — lower interest rate encouraging spending. But not in the traditional sense of encouraging them to borrow, but rather the basic idea of using their money and enjoying life. And this is fine, as long as their overall financial security is not put at risk.
So clients are buying that sports car they always wanted, going to Canada, renovating their kitchens, or helping their children/grandchildren.
Discouraging spending
But there is a flip side. Low returns are scary. For the first time, many retired clients are seeing their capital not increasing (drawings exceed total earnings) and therefore they have pulled back their spending. This is very logical, and for many it is absolutely essential.
This time is different — low rates are not helping
It is clear that lower interest rates are beneficial to borrowers and detrimental to investors with cash. But with the general apprehension in the Australian economy, borrowers are not necessarily going to “take advantage” of lower interest rates to “buy now and pay later”. Low interest rates (and hence low return expectations) are slowing down most peoples’ desire to spend, no matter what stage in life they are.
The Failed Experiment
With interest rates around the world effectively at zero, and no sign of growth as a result, there are plenty of reasons to assume the theory is wrong, or at least are not applicable to the current situation.
The key take out of this situation? If you feel very comfortable about your financial situation, then enjoy it. If there is that one thing that is more a want than a need, seriously look at doing it. I cannot say that leaving the money with me with result in some massive return.
But if you do not feel comfortable with the ability of your capital to outlast you — then please proceed with care and consider moderating your spending.