A matter of interest rates

The Reserve Bank has cut its cash rate again and Joe Hockey apparently says this is bad news for the economy (I say apparently because I couldn't find a record of him actually saying it). PM Rudd says Mr Hockey's comments are a kick in the guts to families struggling with cost of living pressures.

Like most political statements (or apparent statements) neither is correct, but both are easily turned into slogans to fire out on Twitter. (As an aside, it beats me why we bother with the cost of elections when we could just see who's trending on Twitter. And for the record, for those who think Twitter is a news service, that was a joke!)

Lower interest rates aren't bad for the economy. Falling mining investment, declining terms of trade, high personal debt levels and excessive Government interference are bad for the economy. Lower interest rates come after things have gone bad, in the hope that mis-pricing money will make things better.

They don't ease cost of living pressures either. Try telling someone with an age pension, some term deposits and a capital stable super balance their cost of living situation has been improved over the last few years.

They do help the highly indebted - mortgage borrowers, property speculators, margin loan borrowers - and they're great for helping along the share prices of banks and property trusts. But that assumes you've still got the same level of income you had a couple of years ago, or you bought the right shares.

What do lower interest rates mean for us as investors?

Firstly, the high levels of Government interference means there's a good chance money is being hopelessly mis-priced. So we should be more conservative than usual because it's impossible to tell what type of blow up this might cause down the track.

This is where monetary policy theory starts to break down. Extreme policy scares those with cash into conservatism and lower spending. And it scares borrowers into paying off their loans. A transfer of cash from savers to borrowers is either good for balancing out debt levels (savers effectively pay down the debt of borrowers) or increasing consumption (by savers being forced to give their money to consumers), but not both.

The second big point for investors is the importance of diversification, not just within an Australian share portfolio but internationally (and across asset classes) as well. Across the Intelligent Investor group, we keep pushing the international bandwagon but it's a critical part of the Australian investor's defense against our politicians and their meddling ways. Longer term, we can't have a weak economy, extremely low interest rates and a high dollar. Something has to give.

Thirdly, whilst monetary policy might be extremely loose in nominal terms, there's the still the chance it proves to be too tight. If we see even mild deflation (especially in property prices), those with cash earning 4% might be very happy with their real returns and newfound purchasing power (despite the lack of nominal earnings). It's very tax effective as well, since we don't tax increased capacity to spend.

When it comes to politicians and central banks, this is the one ray of light for savers: in the absence of inflation, their ability to destroy your savings is limited by the lack of negative interest rates. It's one of the design flaws (from the politicians perspective) in our financial system. Mind you, in Europe they're working on it.

Lower interest rates might be bad news for Joe Hockey (and Kevin Rudd, if anyone manages to ask the right questions) but, for investors, a lower RBA cash rate is just another bit of information to take into account. If they stay where they are, or move lower, its ultimately likely to coincide with lower asset prices (especially property) - improving spending power and providing buying opportunities for those with cash - and if they move up it's likely to be a sign that growth has strengthened (good for some shares).

Despite a sub-3% RBA cash rate, it's borrowers that have more to worry about longer term. They either cop falling asset prices with their low interest rates - wiping out their equity while they save on debt repayments - or rising interest rates without the fuel for an asset boom.

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