Archive for July, 2008

When will serious inflation catch up with us?

Thursday, July 31st, 2008

Recently, one of our readers asked us this question:

If, as you have reported, our money supply is still increasing at over 20% per annum, what is this likely to lead to in terms of price inflation in the years ahead? I suspect that it will somehow catch up with us one way or another, and the result will not be pretty. But this is just a generalised gut feeling, which is not as useful as a more particularised and detailed understanding would be for positioning oneself for the inevitable. Part of a clearer vision would be, of course, a better sense of the likely timeframes involved. How long before the ugly bits start to catch up with us, and how long will it be likely to last? What will be the signs of imminent danger? Or do we already have plenty of them now, as we speak?

First, for those who are new to this publication, we would highly recommend that you read Cause of inflation: Shanghai bubble case study before continuing reading the rest of this article. The reason is because mainstream economics and the Austrian School of economic thought have different definitions for inflation. To make our language more precise, we will refer to the former’s definition simply as price rise and the latter’s definition as monetary inflation. If you have time, you may want to read our guide, What is inflation and deflation?.

Next, the point of this article is about recognising the signs of inflation- we are not airing our opinion on what will happen in the future in this article. Our opinion for that can be found in Inflation or deflation first? instead.

Here are two considerations to think about when considering the future effects of monetary inflation:

  1. One troubling aspect when discussing the economic phenomenon of price rise is the indices used to measure it. As we argued before in How much can we trust the price indices (e.g. CPI)?, the whole idea of measuring general price levels is logically invalid. For instance, as we said in that article,

    … the world is experiencing unprecedented asset price inflation. In Australia, it is the housing price bubble. Since the Reserve Bank of Australia (RBA) does not have the mandate to prick asset price bubbles, then can we give them such a mandate by merely redefining houses as consumer durable goods and include them in the basket of goods in the price index calculation?

    That is, if we include houses as part of the basket of goods in the CPI, Australia will be suffering from severe inflation for the past 10 years! One way for governments to deny the severity of price rises is to fudge the figures and the composition of goods and services, which is what the US government is arguably doing right now.

  2. Also, as we said before in Introduction to the famous Quantity Theory of Money, according to the Austrian School of economic thought,

    Monetary inflation (or ?printing? money or increasing the money supply) results in the distortion of the relative price levels. That is, when money is ?printed,? prices will be affected in varying degrees for different things with different time lags (see How to secretly rob the people with monetary inflation?).

    Monetary inflation takes time to work itself out to the rest of the economy. Sometimes, the effect is not immediate. For example, for the past 10 years, monetary inflation did not result in visible price rises. In fact, thanks to the rise of Chinese manufacturing, we have price falls of manufactured goods, while at the same time, the price of houses sky-rockted (see The Bubble Economy). But lately, we see the rise in the prices of commodities, food and oil. To add to the difficulty, the effect affects prices of different things with different time-lags. Some goods and services are are susceptible to monetary inflation than others.

    Next, monetary inflation may not affect the price levels of of everything to the same degree. For example, the past rise in house prices was probably not going to be accompanied by as great rises in the price of funeral services.

In view of these two considerations, you can see why it is not easy to give a straight answer to our reader’s question. But before hyperinflation can develop, there will be plenty of warning signs. An exponential increase in the supply of money is one sign. The conditions that we described in What is a crack-up boom? is another. Governments turning towards populism and fiddling with the laws is another (see Recipe for hyperinflation). In other words, while you cannot know the precise time-frames of such development, you will have plenty of time to prepare for it as long as you keep your eyes and ears wide open. In addition, the initial stages of inflation are akin to a silent killer that is slowly doing its destructive work. But as it move towards the finale (i.e. hyperinflation), you will see the acceleration of developments.

Thus, we would encourage you to acquaint yourself with history in order to help you recognize the signs. We will be watching and listening too. You will get to see what we see and hear what we hear both in this publication and on our sister site: Contrarian Investors’ News.

Is the world already in recession?

Wednesday, July 30th, 2008

The answer to that question depends on your definition of recession. Sticking to the technical definition favoured by central bankers, the world growth is just “slowing.” But as we argued in Example of precisely inaccurate information,

Now, if the price index is a logically invalid number (let alone accurate), then how accurate will real GDP growth figures be for capturing the growth of output of an economy? If this figure is inaccurate, then how accurate will it be for defining when an economy is technically in recession? In that case, how useful will it be to be so precise in defining the exact point for which the economy is in technical recession?

What about the people on the streets? In a recent interview with Marc Faber at Faber Says Fannie, Freddie Should Split Up, Not Get Aid, he said

I travel a lot as you may know. And I can tell you in the last two months I was around the world twice. Everywhere I ask how is business and business is down everywhere. Everywhere it slowed down very considerably. And it is lower than a year ago. So I suppose you can say the world is in recession already.

One of our contacts in China told us stories about factories being forced out of business due to the falling US dollar and falling US demand. Many of these factories have very low profit margins. One particular factory is currently losing money. Yet, if it closes down, it will lose even more money. Therefore, it is forced to continue production at a loss. This anecdotal evidence is consistent with the numbers and our outlook (see China?s slowdown & its implication for Australia).

What will be the worst case scenario for the world economy? As we said before in June 2007 at Epic, unprecedented inflation,

Today, the world is experiencing an unparalleled inflation of asset prices. This is the first time ever that the world is experiencing asset price inflation in all asset classes (e.g. property, bonds, commodities, stocks and even art!) and in all major nations (e.g. US, China, Japan, Australia, UK, Russia, etc). We will repeat this point again: never before had such a universal scale of asset price inflation ever happened in the entire history of humanity!

Marc Faber believes that the end of this universal boom will be a “colossal bust.” As he explained in the interview at Faber Says Fannie, Freddie Should Split Up, Not Get Aid, the worst case scenario is that this colossal bust will be

… with inflation. I think there is a very good chance that we will have bad economic environment but still rising prices simply because we have money printing institutions around the world called central banks.

At the same time, Marc Faber has scathing remarks about Ben Bernanke and the Federal Reserve,

… the Fed is totally ineffective and inept organisation. That has to be said, they don’t understand simple economics. Because Mr Bernanke reads and writes about the Depression years; the difference between the Depression years and today is that commodity prices had peaked out in 1921 and they were in well-established down trend. Today’s situation is that there are 3 billion people are joining the global economy who are eating and driving around more and more and they put pressure on commodity prices. This is an inflationary environment, not a deflationary environment. And if some Fed member does not understand that, then he shouldn’t be at the Fed in the first place.

It looks like Marc Faber is in the long-term inflation camp (see Are we heading for a deflation or inflation? for the quick run-down on the inflation-deflation debate). And we must emphasize the adjective, “long term,” in the previous sentence, just in case others will think that we do not believe deflation can happen.

Does bank asset write-down directly reduce the money supply?

Tuesday, July 29th, 2008

There is a very common misconception that when a bank writes down the value of its asset (e.g. due to bad debts), money supply will shrink. To be honest, we had this misconception ourselves before and we are writing this article to address this issue. The reality is that when bank assets are written down, there is no direct contraction in money supply. The contraction in money supply will be an indirect effect.

To see why, a basic understanding of corporate accounting is required. Therefore, we will recommend that you read Introduction to banking corporate accounting and Effect of write-down on bank balance sheet before continuing. As you read these two articles, what do you notice when a bank writes down an asset? You will notice that bank deposits are untouched when that happens. Since bank deposits make up part of the supply of money, there is no direct contraction of it as a result.

But money supply can contract as an indirect effect when banks becomes much more cautious in issuing loans or stop re-issuing loans when they get repaid. This can happen as their minimum capital and reserve requirements are breached, which means they have to either sell their assets or raise more equity.

Since a severe and sudden contraction of money and credit supply can have a devastating effect on the economy, the central banks and government will do anything to help banks to continue issue more loans. This may mean changing the laws to reduce the minimum capital and reserve requirements, swapping suspect assets for government bonds and so on.

How well informed is NAB’s CEO, John Stewart?

Monday, July 28th, 2008

On Sunday’s Inside Business interview with NAB’s CEO, John Stewart (regarding the recent write-down of $1.2 billion US home loans securities), there were some things he said that made us wonder how much he understands:

Taking those one at a time, I mean the rating agencies clearly are under pressure but in their defence, they couldn’t have foreseen the meltdown that’s gone on in the United States housing market.

Well, “couldn’t have foreseen” is a very common excuse. As we said before in An example of how the sub-prime contagion may spread, economists from the Austrian School already had strong reservations about the Housing Economy as early as 2004! Very long time readers of this publication would already know that we first voiced out our reservations in October 2006 in The Bubble Economy.

Next, John Steward said:

Well the answer to that really is that the only error NAB made was investing in Triple-A securities which have a one in 10,000 chance of defaulting…

Basically, what he is saying is that NAB was extremely unlucky, which it implies that it is none of their fault that this should happen. But as we said in How the folks in the finance/economics industry became turkeys?Part 2: The Bell curve, that great intellectual fraud,

The problem with mainstream thinking in today?s finance and economics industry is that the Bell curve is their cornerstone assumption. In other words, the Bell curve assumption is used extensively to model reality and derive conclusions and forecasts.

Unfortunately, the model of reality is completely incorrect. As such, nonsense such as the ones said by John Stewart get repeatedly perpetuated on TV. As we quoted Nassim Nicholas Taleb in How the folks in the finance/economics industry became turkeys?Part 2: The Bell curve, that great intellectual fraud,

If the world of finance were Gaussian [Bell curve], an episode such as the [1987] crash (more than twenty standard deviations) would take place every several billion lifetimes of the universe.

Given the fact that so many of such Triple-A securities in the US had already blown up, it is simply too ridiculous for anyone to believe that each of the blow-ups is a one in ten thousand year event.

The question is, why are such Triple-A securities given such high ratings when clearly, they are junk? To answer this question, we will refer you to our earlier article, Collateral Debt Obligation?turning rotten meat into delicious beef steak, to understand how CDOs work. Basically, through some ‘brilliant’ financial innovation that utilises complex mathematical models, junk bonds get re-engineered into AAA bonds. Unfortunately, there is a major flaw in those mathematical models. As this article from Platinum Asset Management said,

In particular lower rated tranches of mortgage securitisations (say BBB rated tranches) were pooled. The first cash flow on these tranches was sold as a AAA-security – the argument being that it was improbable that most of the BBB securities would default. This would be true provided that the BBB pools are themselves not highly correlated. If they prove to be highly correlated (as appears to be happening in the subprime mortgage area) then just three BBB tranches defaulting would indicate it was likely that a majority would default. Then the seemingly safe AAA paper might actually be quite risky.

If you do not fully understand what we mean, do not worry about it. The complex maths behind these toxic derivatives are meant to be un-decipherable to mere mortals and we do not pretend to understand all of them ourselves. But this fundamental fact remains: these models are convoluted and wrong. For this reason, perhaps we cannot blame John Stewart for having stuff up because he (and by extension, NAB) is probably being suckered by the dazzling world of derivatives.

Personally, we do not think John Stewart is deliberately being deceptive. Rather, we believe it is more likely that he (by extension, NAB) are simply not well-informed enough. In other words, NAB do not know what is going on. The same probably goes for the other banks too.

Effect of write-down on bank balance sheet

Sunday, July 27th, 2008

On Friday, National Australia Bank reported a $830 million write-down on their assets. As this news article, More NAB bad debt revealed reported,

National Australia Bank’s senior management has been castigated by banking analysts after the bank released a fresh $830 million writedown of its investments in US housing mortgages.

The stock market reacted by plunging 3.5% at the time of writing. Will there be more? We will leave it to the mainstream media chatter to talk about it. Meanwhile, we will show you how a write down will affect the bank’s balance sheet. For this, we continue a simplified bank balance sheet from Introduction to banking corporate accounting:

Asset: $98.50 (Loans), $10.50 (Cash)
Liabilities: $105 (Deposits)
Equity: $4

Let’s say 2% of a bank’s non-performing assets is being written down. That means $1.97 of the asset will be gone. In that case, the asset part will look like this:

Asset: $96.53 (Loans), $10.50 (Cash)

But what about the liabilities and equity side of the balance sheet? The liabilities side remains intact because they represent the saver’s deposit. Therefore, it will be the equity side that gets deducted:

Equity: $2.03

The balance sheet now looks like this:

Asset: $96.53 (Loans), $10.50 (Cash)
Liabilities: $105 (Deposits)
Equity: $2.03

In one write-down the bank’s capital ratio gets reduced to 2.03/96.53 = 2.10%. It’s reserve ratio is still 10%. Will it get into trouble? As we explained before in Banking for dummies,

At its very core, a bank borrows money at lower interest rates and lends them out at higher interest rates. Its borrowings are its liabilities while its lendings are its assets. When you deposit your money into the bank, your money is the bank?s liability but your asset. In accounting technicalities, your money goes into the bank?s balance sheet as an asset with a corresponding liability.

Let’s say the bank pays 9.5% interest rates to its depositors (liabilities) and receives 10% interest rates from its loans (assets)- assuming interests-only payments. That means it will have to pay $105 * 9.5% = $9.975 to its depositors and receives $9.653 from its loans. In this case, the bank is in trouble.

Or let’s say banking regulations says that the capital ratio cannot go below 4%. Currently, it is at 2.10%, which means it is in trouble. It has to either sell its assets or raise cash (via equity raising) to bring the ratio up again.

No matter what, the bank’s profit will fall.

Introduction to banking corporate accounting

Thursday, July 24th, 2008

Today, we will go deeper in depth on corporate accounting for banks. Without a proper understanding of this, it will impair our ability to appreciate a bank’s financial position. Back in Banking for dummies, we explained that

At its very core, a bank borrows money at lower interest rates and lends them out at higher interest rates. Its borrowings are its liabilities while its lendings are its assets. When you deposit your money into the bank, your money is the bank?s liability but your asset. In accounting technicalities, your money goes into the bank?s balance sheet as an asset with a corresponding liability.

Today, we will go deeper into that.

First, we will introduce the basics of accounting:

Assets = Liabilities + Equity

So, let’s say you deposit $100 into the bank. In this case, the highly simplified bank’s balance sheet will be:

Assets: $100 (Cash)
Liabilities: $100 (Deposits)
Equity: $0

In this example, the bank is losing money because it is borrowing $100 from you which it has to pay interests on. But its $100 of cash is sitting there idle. Therefore, the bank has to lend out, say $90 at a higher interest rate than it borrows the cash from you. The balance sheet will now look like this:

Asset: $90 (Loans), $10 (Cash)
Liabilities: $100 (Deposits)
Equity: $0

Let’s say it pays 5% p.a. interest rates on deposits and receives 10% p.a. interest rates on its loans. At the end of the first year, the bank balance sheet will be (assuming interest-only payments on loans):

Asset: $90 (Loans), $19 (Cash)
Liabilities: $105 (Deposits)
Equity: $4

Now, there are 2 ratios that you need to understand. First, government regulations require that banks keep a certain ratio between equity and risky loans (in the assets) that it makes out to others. We shall call this the capital ratio. In this example, the capital ratio is 4 (Equity)/90 (Loans), which gives 4.44%. That is, its leverage is 22.5 times. There is another ratio called the reserve ratio, which is the ratio of cash and deposits. In this example, the reserve ratio is 19 (Cash)/105 (Deposits), which gives 18%.

Now, let us assume that the reserve ratio has to be, by law, a minimum of 10%. In that case, this bank has an excess reserve of 8% (see 363 tons of US dollars to Iraq?how much money will eventually be multiplied into the economy?). It can lend out an additional $8.50 to give a balance sheet of:

Asset: $98.50 (Loans), $10.50 (Cash)
Liabilities: $105 (Deposits)
Equity: $4

In this case, its reserve ratio is $10.50/$105, which gives 10%. Its capital ratio is 4/98.5, which gives 4.06% (leverage of 24.6 times).

How safe are Australian banks?

Wednesday, July 23rd, 2008

There are widespread beliefs that the Australian banking system is safer and more conservative than their overseas counterparts. Thus, it is generally assumed that the sub-prime and credit crunch problems that affected the US will not happen in Australia. But is this a reasonable assumption?

First, as we showed in Australia has no sub-prime debt? Think again!, there are real-life examples of dodgy lending by Australian banks. The question is, how widespread is such lending? Are these examples of dodgy lending indications of a systemic problem? In any case, it is obvious that it is not in the banks’ best interest to be forthright about their dubious lending practices. Perhaps you may want to do your own scuttlebutt research on this. If you have any stories about dodgy lending practices or dodgy borrowing, please feel free to share them in the comments section below.

Next, our suspicion is that Australian banks are severely underestimating their vulnerability. As Brian Johnson, a banking analyst from JP Morgan was quoted in Banks to feel more pain: analysts,

Mr Johnson believes that Australia’s banks are failing to envisage the possibility of a loan-loss cycle where asset prices [such as housing] fall, and banks struggle to recover loans from defaulters and forced sales.

Mr Johnson said Australian banks are actually more vulnerable to the credit crunch than many of their global counterparts because of their high levels of gearing, or loan to capital ratios.

We’re talking banks geared 25-30 times, whereas the global peers may be geared 15-20 times… even a moderate loan-loss cycle creates negative earnings,” he said.

As we said before in Aussie household debt not as bad as it seems?,

A severe downturn to the Australian economy may or may not be statistically likely, but given the level of unprecedented leverage, you can be sure the impact will not be small. Be sure to understand the concept of Black Swans (see Failure to understand Black Swan leads to fallacious thinking).

In addition, the Australian banking system has a vulnerability not shared with other countries. As this news article, Fast rise of round robin lenders, reported,

The Reserve Bank of Australia has a dark worry about our banks: they get 90 per cent of their cash from each other. If one bank gets into trouble, the Australian financial system could be snap-frozen overnight.

We will give a highly simplified analogy of this problem. Imagine an economy of 3 people: Tom, Dick and Harry. Tom owes Dick $1000, Dick owes Harry $1000 and Harry owes Tom $1000. Each of them will have a balance sheet that looks something like this:

Asset: $1000
Liabilities: $1000

For each one of them, what they owe are their liabilities and what they are owed are their assets. Let’s say, for whatever reasons, Tom is unable to honour his debt repayment to Dick. In that case, Dick’s asset will go bad. As a result, he is unable to honour his debt repayment to Harry. This in turn caused Harry’s asset to go bad, which affected his ability to repay his debts to Tom. Therefore, one person’s debt problem becomes a contagion that spreads to everyone else.

In a similar way, this is the current vulnerability of the Australian banking system. It is unique to Australia because of the shortage of government debt that could be used as bank assets and collaterals, thanks to the previous government’s budget surplus. We suggest that you read our earlier article, Banking for dummies for more details about bank balance sheets.

Of course, though it may be possible that such things may happen, it does not necessarily mean that it will happen. It’s the job of the RBA and APRA to prepare the drills in anticipation of this worst case scenario. But should it happen, what can be the possible triggers? For the answer to this question, one news article, ANZ is the big local bank most at risk, caught our eye:

ANZ Bank has been singled out ahead of other big Australian banks as most at risk of further material provisions because of its long credit default swap positions, potentially running to $2.4 billion, based on international comparisons.

National Australia Bank is not far behind in the structured credit risk stakes.

As we highlighted before in How the CDS global financial time-bomb may explode?, Australia is not going to escape unscathed when this potential disaster strikes.

In view of all these, perhaps there is little wonder that, as Fast rise of round robin lenders reported,

At a recent conference held by one of the world’s largest banks, the Australian banking system was identified as one of the best investment opportunities, for going short.

China’s slowdown & its implication for Australia

Tuesday, July 22nd, 2008

Back in February this year in Will China slow down from 2009?, we said that

Dear readers, do you see what we are trying to mean? Make no mistake about this: the Chinese economy will slow down appreciably for the Olympics. We believe it will not be just a quick and temporary once-off slowdown- rather it will be a time for the Chinese economy to take a breather and cool down significantly, both by the design of the Chinese government and the effects of a US recession. The giddy and euphoric economic growth of 2007 will not be so ecstatic in 2008 and beyond (but not forever, we guess- but touch wood, if China fall into total social breakdown, then all bets are off… again, touch wood).

It is clear that at the eve of the Olympics, statistical numbers revealed that China’s economy is slowing. As this article from FN Arena reported, China Slowing,

Chinese growth in the June quarter declined to 10.1% from 10.6% in the March quarter, an outcome slightly below consensus forecasts of an increase of 10.3%. According to Danske Bank the shortfall was largely the result of weaker export growth, as domestic demand continues at solid levels.

There are anecdotal indications of this too. Marc Faber, in a recent interview a few weeks ago (see Marc Faber: Let Big Brokers Fail; Buy Gold Not Oil ), said that

As you may know, I travel extensively and I’m not an economist like Mr. Ben Bernanke who reads textbooks and write papers; but I talk to people. And I can assure you: worldwide, there has been a meaningful slowdown in business. And I believe that the demand for commodities will come off in the second half of this year… very meaningfully, including demand in China and India and so, near term, I’m negative about commodities and I wouldn’t buy there here; whereby the commodities bull market may still be intact for many years to come…

At this point, we have to ask these crucial questions: (1) Is this Chinese slowdown merely a temporary blip for the sake of the Olympics (i.e. after the Olympics, the break-neck growth will resume again)? (2) Or is it, as we explained in Will China slow down from 2009?, a chance to catch a breather for a while? (3) Or worse still, a pre-cursor to a major economic correction, as we explained in Can China really ?de-couple? from a US recession??

The theory supporting (1) is that many of China’s factories closed to clear the air for the Olympics. Therefore, according to that theory, production will resume once the Olympics are out of the way. However, there is another theory against (1)- many Chinese infrastructure investment spending are for the glory of the Olympics show-case. Therefore, once it is out of the way, such investments will not proceed in the same intensity as before.

For (3), we cannot really quantify the risk of such happening. Even if it is going to happen, it may not be imminent. This falls into the realm of Black Swans.

Our feeling is that, (2) is the most likely outcome. If that is the case, what will be the implication for Australia? Well, the mining sector may be doing just fine, albeit with a limited slowdown. It will not be as hot as before, when the resource boom was at its maximum intensity a couple of years ago. But with the rest of the economy slowing down, we doubt Australia’s mining sector can pull the rest of the country out of this lethargy. That is where the danger lies. With so much debt lying around, Australia’s economy cannot afford to slowdown. If it slows down too much, the economy may stall and fall into a serious recession. As we explained before in Can lower interest rates re-inflate the property price bubble?,

But what if the economy slows down too much for the RBA?s liking? In that case, given the high levels of debt of Australians, if the economy slows down too much, the Australian economy can tip into a dangerous downward deflationary spiral.

Please note: we are NOT predicting this will happen in the forecasting sense.

Can falling interest rates and rising mortgage rate come together?

Monday, July 21st, 2008

Yesterday, in Too eager for an interest rate cut?, we said that

Fourth, an interest rate cut by the RBA need not necessary mean a cut in the mortgage rate. In fact, the opposite can occur.

Today, we will elaborate on that.

A large fraction of Australia’s borrowed money is sourced from overseas through the ‘shadow’ banking system. In other words, there are not enough domestic deposits to fund all the needed credit (e.g. home loans) in this country. As we explained before in Rising price of money through the demise of ?shadow? banking system, with the fall of the ‘shadow’ banking system, the supply of credit shrinks. This resulted in a rise in the price of money.

That is why non-bank mortgage lenders (e.g. RAMS) found their business in trouble. Because they are not banks, they do not have access to deposits to fund their lending. Their only source of funding is through the ‘shadow’ banking system. When money from that system dried up (i.e. credit crisis), they could no longer lend money as cheaply as before.

The banks, on the other hand, are not left off the hook. Because of their deposit base, they are in a better to weather the credit crisis storm. But overall, there is still a shortfall of deposits to provide for all the demand for lending. As the de-leveraging of the global financial system continues, the price of money will continue to increase. This left the banks with two choices:

  1. Increase the cost of loans (e.g. mortgage rate).
  2. Attract more deposits with higher interest rates- that’s where all the attractive term deposit interest rates from the banks come from.

For Australia to be completely free from the ‘shadow’ banking system, two things must happen:

  1. Borrowing must decrease.
  2. Savings must increase.

This is the only way to bridge the gap left by the credit crisis in the absence of any central bank intervention. We believe that the credit crisis will worsen (see Is the credit crisis the end of the beginning?), which means the gap will widen, which in turn implies even higher lending rate. Since the Australian economy is very much addicted to credit to keep going, any dramatic fall in its supply will have serious repercussions. What to do if such a day eventuate?

Not to worry, because Australia has a central bank (note: sarcasm here)! Since the Reserve Bank of Australia (RBA) is the only institution that can create credit out of thin air, we can be sure they will cut interest rates and be the lender of last resort when the day of reckoning comes. But that does not necessarily mean that mortgage rate will come down too, as reported in this news article, RBA rate cuts may fail to ease mortgage pain,

National Australia Bank chief economist Alan Oster, just back from a month in Europe, said a reprise of the British experience, where banks failed to ease the burden on borrowers despite official rates falling 75 basis points over six months, was not out of the question.

Too eager for an interest rate cut?

Sunday, July 20th, 2008

Ever since the governor of the Reserve Bank of Australia (RBA) made the speech last week, the mainstream media has been catching on to the idea that interest rates in Australia is at the peak and the next move will be a cut. For example, The Age came up with a highly misleading and sensationalising headline: RBA chief throws borrowers a bone. We are sure that such headlines will give some property ‘investors’ (read: speculators) the wrong idea that the property bubble will re-inflate when such a day arrives.

First, let us understand the context of what Glenn Stevens said. In Australia, our central bank has a policy of targeting inflation within a band of 2% to 3%. Note: If you want to know the long story about how inflation targeting come about as a policy, take a read at our earlier article, Why should central banks be independent from the government? which contains a link to the RBA’s web site. There are some who fear that with the credit crisis and rampaging oil prices, any rigid and inflexible adherence to the inflation target band through monetary policy will result in a serious crisis for Australia. In other words, the belief is that the RBA should be flexible enough to let inflation veer off the course. We believe it is in this context that Glenn Stevens reportedly said that he will not “wait until inflation has retreated below 3 % before cutting interest rates.”

Second, though it may be true that the next interest rate move in Australia will be down, it may not be imminent. In fact, it may be quite a while before it happens. So, those who are waiting for an interest rate cut to do wonders to their asset speculation should not be too hopeful yet.

Third, should interest rates be cut sooner than expected, it will probably happen in the context of a credit deflation, which is hardly good for asset prices. In other words, you will not want to see the day when the RBA is forced to cut interest rates desperately because it will be a day when the economy is slowing too dangerously. As we said before in Can lower interest rates re-inflate the property price bubble?,

But what if the economy slows down too much for the RBA?s liking? In that case, given the high levels of debt of Australians, if the economy slows down too much, the Australian economy can tip into a dangerous downward deflationary spiral.

Fourth, an interest rate cut by the RBA need not necessary mean a cut in the mortgage rate. In fact, the opposite can occur. How? Why? We will discuss more about this in our next article. Keep in tune!