Posts Tagged ‘interest rates’

Cost of credit or availability of credit?

Tuesday, October 7th, 2008

As you will already know by now, the Reserve Bank of Australia (RBA) cut interest rates by 1% today, which was more than what the financial market expected at 0.5%. What a bold move! Or is it a sign that the RBA is panicking? Or perhaps is it a result of a plan by central banks around the world to synchronise their rate cuts in order to soothe the global credit market?

There are plenty of commentaries about this surprise move by the RBA and we wouldn’t repeat them here. But there is something in the RBA statement that caught our eye:

The recent deterioration in prospects for global growth, together with much more difficult market conditions even for creditworthy borrowers, now present the risk that demand and output could be significantly weaker than earlier expected. Should that occur, inflation would most likely fall faster than earlier forecast.

The issue is not so much that the cost of credit is too high. Rather, the availability of credit is becoming the issue. What’s the implication?

Remember, back in Econ101 at university, you may have learnt to draw the demand-supply graph whereby the ‘market price’ is the intersection between the demand and supply? The assumption behind the demand-supply graph is that supply is always available as long as one is willing to pay the price. Thanks to freeze-up of the global credit market, this assumption is no longer true. That is, credit may not even be granted even if one is willing to bid for it at a higher price.

Assuming that the credit crisis will drag on, this means that more and more borrowers may soon find that lenders are no longer willing to lend despite being willing to do so previously. In other words, lending standards will be tightening even further. The implication is that more and more borrowers (whether businesses or households) who need to refinance or roll-over their loans may suddenly find that the supply of new credit are being denied.

This will be the point when the crisis in the financial markets spread to the real economy. As Alan Kohler wrote in Interest rate give and take,

If credit ain?t available, it doesn?t matter what it costs.

RBA’s interest rates dilemma

Wednesday, September 3rd, 2008

Yesterday was the first time in several years that the Reserve Bank of Australia (RBA) decided to cut interest rates. As you can read from the mainstream news media, this fall in interest rates is not necessarily good news. For example, Ross Gittins from the Sydney Morning Herald said in Yippee, the bad times are back,

YOU beauty. Interest rates have been cut and happy days are here again. For good measure, we’ve even got petrol prices coming down.

Sorry, don’t be too sure about that. The Reserve Bank has cut its official interest rate only because times are getting tougher.

But our loyal readers should already know about this fact long time ago. Back in July last year (2007), when the talk in the market was still about booming asset prices and inflation, we warned in Should you purchase first home whilst asset price inflation?,

… it is prudent to arrange their finances with the assumption that interest rates are going to be in an upward trend for at least in the medium term. Having said that, it is still possible for interest rates to be cut? when the economy is hit by a threat of recession or depression

While those heavy in debt would welcome RBA’s interest rate relief, there are still many unresolved complications. The most important thing to remember is that Australia’s price inflation problem is still not yet resolved. The RBA is forecasting rising price inflation till the end of the year at least. Normally, no central bank will cut interest rates in the face of rising prices. But this time, they have a bigger worry than rising prices- economic recession. In other words, Australia is facing stagflation (economic stagnation/downturn and rising prices) and the RBA is more worried about the ‘stag’ part of the stagflation. And they are betting that the ‘stag’ part will somehow resolve the ‘flation’ part.

But from what we can see, the RBA’s hands are tied. If they try to prevent the slowdown from turning into a rout by slashing interest rates aggressively, it is very likely that the Aussie dollar will continue its down trend. As we explained before in Falling currency and inflation,

A rapid depreciation of the Aussie dollar will result in rising price inflation for the same reasons stated above.

We do not envy the job of the RBA. It looks like Australia may be moving towards the same path as the US (see Supplying never-ending drugs till stagflation).

Why is the RBA backflipping on interest rates?

Wednesday, August 20th, 2008

It was just a few months ago, the Reserve Bank of Australia (RBA) was very hawkish on interest rates. Its priority was to fight price inflation and with that, even approved of the banks raising their mortgage rates. It was said that if not for the mortgage rate rises, the RBA would have raised rates even more.

It seems that all of a sudden, the RBA began to hint strongly about cutting interest rates. What is going on? As this article,  The Great Interest Rate Forecast Back Flip, reported,

Indeed, the Macquarie analysts are actually concerned the sudden turnaround in RBA intention suggests it might know something about the economy we don’t. “Has the RBA’s business liaison program revealed some financial fragility in the economy that has not yet been unveiled?” while suggesting that “for this reason lower interest rates are unlikely to be the green light for growth investors might hope for”.

One thing many experts even fail to understand is that a fall in interest rates does not automatically mean a loosening monetary policy. As we explained before in What makes monetary policy ?loose? or ?tight??,

A common misperception is to assume that any rise in interest rates automatically implies a monetary tightening (and conversely for a fall in interest rates).

What had been happening is that the demand for credit in the Australian economy is decelerating very rapidly. That is, Australian households, individuals and businesses scaling back on their borrowings. When the demand for credit slows down tremendously, what was before a ‘loose’ monetary policy can become ‘tight’ all of a sudden.  If credit demand falls further, the RBA can still cut interest rates and still have ‘tight’ money. If you are confused by this, please read our earlier article, What makes monetary policy ?loose? or ?tight??.

The best way to explain this concept is to use Japan as an example. In the 1990s, Japan famously cut interest rates to zero. Yet, asset prices kept on falling for 16 years straight. That is an excellent example of deflation whereby credit became a dirty word. Even when interest rates was zero, Japan’s monetary policy was still ‘tight.’

For Australia, a rapidly decelerating credit growth is very bad news. Since a lot of Australian consumer spending is financed by the growth of credit, this will mean a severe slowdown in the Australian economy. Furthermore, rising asset prices is fuelled by exponential increase in credit. A rapid deceleration of credit growth will result in asset price deflation.

We can imagine the RBA worrying about the storm clouds gathering ahead- US is in recession, UK is going to fall into recession, Europe is stumbling into recession, Japan is feared to fall into recession, falling commodity prices, China is slowing down, etc. If the rest of the world economy is slowing down significantly, there is no way Australia can escape.

Would the RBA’s rate cut do any good?

Wednesday, August 6th, 2008

On Tuesday, the Reserve Bank of Australia (RBA) hinted that the case for an interest rate cut has increased. As this announcement from the RBA said,

Weighing up the available domestic and international information, the Board judged that the cash rate should remain unchanged this month. Nonetheless, with demand slowing, the Board?s view is that scope to move towards a less restrictive stance of monetary policy in the period ahead is increasing.

The last sentence gave the financial markets the excuse to punt on interest rates cuts later in the year. No doubt, many would be eagerly waiting for this day to come. They thought, perhaps, rate cuts would help bring in a new boom in asset prices?

The RBA may cut interest rates, but the price of credit may not follow. You see, when the RBA cuts interest rates, they are merely setting the target of the cash-rate, which is the rate of overnight loans between banks. The cash-rate is only one of the many short-term interest rates. As we explained in How does a central bank ?set? interest rates?,

… there are many kinds of interest rates, which can be categorized into either short-term interest rates and long-term interest rates. An example of a long-term interest rates include the 10-year Commonwealth Treasury bond yield.

The cash-rate will then have an influence on the other interest rates in the economy (e.g. bank bills). Unfortunately, thanks to the credit crisis, this influence had waned. The fact that mortgage rate is moving independently from the cash-rate is testament to that fact.

Then, there is another possible danger. As this article,  Debt mutes the horn of plenty, noted,

Bank deposits have not been enough to fund the rise in household borrowing, so the banks have turned to world markets, which have been more than willing to lend. They are still willing, albeit at a much higher interest rate than was being charged a year ago.

“The funding costs can only get worse if we see interest rates come down here and the currency starts to fall, so that the attractiveness of lending to Australia diminishes,” Minack says.

If the Australian dollar falls as a result of interest rate cuts by the RBA, there are two possible adverse results for Australia:

  1. Foreign lending to Australian households may be reduced, which means the cost of credit will go up, as we explained in Can falling interest rates and rising mortgage rate come together?.
  2. The rise of the Australian dollar has shielded Australian households from the worst of the commodity price inflation, most notably oil. A fall in the Australian dollar will imply a rise in the price of these commodities. This will not bode well for the Australian price inflation rate.

As we explained before in Is the credit crisis the end of the beginning?, the de-leveraging process in the global financial system still has to yet to run its full course. Consequently, the price of credit will continue to rise, regardless of central bank’s rate cuts. The rising price of credit and further credit tightening will lead to further deceleration in credit growth, which in turn will be very detrimental to asset prices and the real economy.

We will not taking RBA’s rate cut as ‘good’ news.

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!

What should the RBA do?

Monday, June 23rd, 2008

Yesterday, our article What is a crack-up boom?, resulted in many interesting responses and questions from our readers. Each of these questions requires very long and thoughtful response. Therefore, we will slowly answer each question chronologically one at a time. If we have not answered all your questions today, please be assured that we will do so in the days to come. The answers come in a first-come-first serve basis.

Today’s article will answer this question:

Do you think that the RBA is doing the right thing then? It has raised interest rates, although it has also bailed out financial institutions.

Let’s start off with what we would do if we were the RBA (and the Federal Reserve). Not only would we raise interest rates, we would have done so very early to prick the emerging asset price bubble right at the start. So, why didn’t the RBA do that? As Ian Macfarlane, the former head of the RBA, said here,

Many people have pointed out that it is difficult to identify a bubble in its early stages, and this is true. But even if we can identify an emerging bubble, it may still be extremely difficult for a central bank to act against it, for two reasons.

First, monetary policy is a very blunt instrument. When interest rates are raised to address an asset price boom in one sector, for example, house prices, the whole economy is affected. If confidence is especially high in the booming sector, it may at first not be much affected by the higher interest rates, but the rest of the economy may be.

Second, there is a bigger issue which concerns the mandate that central banks have been given. There is now widespread acceptance that central banks have been delegated the task of preventing a resurgence of inflation, but nowhere to my knowledge have they been delegated the task of preventing large rises in asset prices which many people would view as rises in the keeping of his wealth. Thus if they were to take on this additional role, they would face a formidable task in convincing the public of the need.

The last sentence is where the problem lies. The masses have not given the RBA the mandate to spoil the asset price inflation party. Although, Ian Macfarlane acknowledged that asset price bubbles can be very dangerous for the economy, his hands were tied. Elsewhere, Coalition opposition politicians were toeing the populist line by demanding that Glen Stevens (the current head of the RBA) be grilled more frequently in order to pressure him against hiking interest rates.

The next question is: should the RBA raise interest rates aggressively now? University of Western Sydney Professor Steve Keen reckoned that it is too late to do so now. His reasoning is because at this point in time, deflation is the greater danger and that inflation, though also an evil, should be left alone for now. We believe his view is that when debt deflation takes hold, it will drag consumer price inflation along with it. Is he right? Well, we are right now experiencing asset price deflation plus commodity price inflation. If the RBA leave inflation alone, our fear is that the seeds of the crack up boom can eventually grow up to become a hyperinflation dragon.

Next, should the RBA bail out financial institutions? So far, they have not officially bail out one yet in the same way the Federal Reserve had bailed out Bear Stearns. But it has certainly absorbed some of the bad debt assets and provided more liquidity. Our view is best summed up by what Jimmy Rogers said in Jimmy Rogers: ?Abolish the Fed?,

If xyz needs to go bankrupt, let them go bankrupt. I promise you, that will send a very straight signal and you will have a lot of self-regulation when these guys start to go bankrupt.

Banking for dummies

Wednesday, April 23rd, 2008

One of the most lucrative business in the world is banking. This is especially true in a world of fiat money and fractional reserve banking system, where money that is backed by nothing can be created from thin air. As we have seen previously in Reserve Bank of Australia entering the landlord business, the central bank can always prevent or prempt a shorter term financial meltdown by pumping liquidity into the system (that is,’printing’ money and then followed by lending them or buying up bad debts or some other tricks- see Recipe for hyperinflation) and introducing moral hazard. But in the longer term, the people have to pay for these moral hazards via inflation.

Today, we will take an introductory look at the business of banking.

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.

Currently, today’s banking system is a fractional reserve banking system. That means banks do not have to keep all your deposit money in its ‘vault.’ Since it is unlikely that you will recall most of your deposit money at any one time, it can lend out the vast majority of your deposit money while simultaneously maintaining the full balance in your bank statements. Legally, banks have to keep a minimum ratio of deposit money in its ‘vault’ to deposit money. This ratio is the reserve ratio, which is 10% in the US. Countries like Australia do not have formal reserve ratio requirement. The implication is that if every bank customer decides to recall all their deposit money simultaneously, the bank is insolvent instantaneously. That is, there is a run on the bank.

As we said earlier, a bank profits by taking a cut between its borrowing and lending interest rates. If it keeps too much deposit money in the ‘vault,’ it is money that is not put in productive use and thus, have a negative impact on its profits. On the other hand, lending money out entails risks of debt default. Side note: With the rise of securitisation (see Collateral Debt Obligation?turning rotten meat into delicious beef steak), banks (and non-banks as well) are able to lend and re-lend money many times over, spewing out massive amount of credit into the financial system.

As you can see by now, the banking business is a balancing act of managing a portfolio of assets and liabilities. Since the banking industry is a highly regulated one, there are rules for them to follow in this balancing act. For example, there are government regulations that require banks to keep a certain ratio between risky assets (loans and bonds) and equity capital (excess of assets over its liabilities). The upcoming Basel II accord is another such example.

The global credit crisis has thrown many spanners in the works of many banks’ portfolio and by extension, the global financial system. As you can see, bad debts is causing the mayhem in banks’ portfolio (see Is this sub-prime or solvency crisis?). When the financial system realised that the price of money was too low for too long (see Prepare for asset repricing, warns Trichet, which is written back in January last year), banks (as well as non-bank) become very much risk averse and hoarded money as a result. In other words, money suddenly becomes scarce (which implies its price, the interest rates has risen).

So, as we asked before in Reserve Bank of Australia entering the landlord business, what might be the “possible repercussions if the RBA had not [got into the landord business]?” When money becomes scarce and banks (as well as non-banks) become more scared, lending seizes up and credit standards become tighter (see Rising price of money through the demise of ?shadow? banking system). For economies that are drugged up by credit (e.g. Australia, UK and the US), this can cause the economic activity to seize up. The fact that the RBA is temporarily swapping risky assets (mortgage bonds) for thin air money at a bargain price is a very telling sign. And it is not only the RBA that is doing this- it looks that other central bankers are coordinating their efforts in pumping liquidity into the financial system. At least this is the official reason. Since the RBA did not reveal who they get their mortgage bonds from, other conspiracy theorists believe that the RBA are bailing out some financial institutions (which include banks and the non-bank lenders).

For bankers, there is such a thing as free lunch.

Why does the central bank (RBA) need to punish the Australian economy with rising interest rates?

Tuesday, March 4th, 2008

Today, the Reserve Bank of Australia (RBA) just announced yet another rise in interest rates. There are signs that this is hurting, as many people on the street (especially those who are straining under enormous debts) are screaming at the madness of the RBA for doing so. Many economists are worried that the RBA may accidentally tip Australia’s economic boom into a bust. Why is the RBA spoiling the party by raising interest rates?

Think about this: if raising interest rates is ‘bad’ and cutting interest rates is ‘good,’ then why don’t the RBA set interest rates to zero, thereby putting the economy into a path of eternal boom (plus runaway inflation)? For those who think this is a good idea, then this article will set to let you understand why this is a bad idea.

Now, at this point, we recommend that you read our guide, What causes economic booms and busts? because what follows will not make sense unless you understand the Austrian Business Cycle Theory (ABCT).

Back in February last year, in Where are we in the business cycle?, you can see that we already knew that Australia (and the US) was already at the top of the business cycle:

How can we restore the economy back to equilibrium and ensure that it remains in a firm footing for the future?

The first thing that has to happen is to increase our national savings. As we said in The myth of financial asset ?investments? as savings, we need to restore and rebuild our stock of capital goods to ensure our future prosperity. Already, the quality of our education, health, telecommunication and transport infrastructures are in decline and they are in need of repair and upgrade. This means that the only way we are going to achieve that is to reduce our current consumptions and cut down our debt. When that happens, the economy will slow down and many businesses and investments will fail as a result. Since most of the Australian (and the US as well) is made up of consumer spending, in which much of it is funded by debt, we can see that this remedy will be painful. If the consumers do not slow down and get their act together, we can expect the RBA to impose a restraint by raising interest rates.

The Australian economy was already running at full steam. Accelerating price inflation is a sign that there are insufficient resources in the economy to allow for all investment projects to succeed and all consumptions to carry on. If this trend is not arrested, the economy will run out of resources, resulting in a crash. Therefore, in order to put the economy back into a sustainable growth path, consumptions and investments have to slow down in order to allow for the economy to catch a breather for the rebuilding of its capital structure. The rebuilding of capital structure is necessary for the economy to replenish its resources for the future so that growth can continue down the track. Unfortunately, this rebuilding itself requires resources now. Therefore, current wasteful consumptions have to be curtailed and mal-investments have to be dismantled to make way for the rebuilding. The curtailment of consumption involves consumers spending less and saving more, while the dismantling of mal-investments involves retrenching workers, liquidating businesses, e.t.c. These involve pain for the people of Australia.

That is why the RBA has to raise interest rates to ‘punish’ the economy. What if it don’t? Then the economy will crash, either in nominal terms (e.g. deflationary depression) or in real terms (e.g. hyperinflation)- see Recipe for hyperinflation.

Another source of potential financial crisis?reversal of yen carry trade

Monday, February 19th, 2007

Interest rates in Japan had been zero for many years. It was only until recently that it had risen to only 0.25%. Such an unusual financial phenomenon sparked an interesting money-making opportunity?the yen carry trade. Basically, in a yen carry trade, you borrow money in Japan (where the interest rate was zero and is now 0.25%) and lend in countries with much higher interest rates. The interest rates differential makes up your profit. There are many ways to play with the yen carry trade. The most conservative way is to invest the borrowed money in US Treasuries. No doubt, there will be some hedge funds who want to achieve higher but more risky returns by investing in more risky assets such as stocks and Shanghai real estate.

What is the risk with this kind of strategy? Well, this strategy counts on the exchange-rate of yen not rising. A rising yen can wipe out your interest rates differential profits, even possible resulting in losses. Thus, the next crucial question is: what can result in an appreciation of the yen? For 16 years, Japan lived under the threat of deflation and economic malaise?that is the reason why the Japanese central bank made its money as cheap as possible (i.e. zero interest rate) in an attempt to counter such an economic threat. It is only until recently that the first lights of economic recovery can be seen. At this point in time, the Japanese economy is still dependent on exports to grow, which means that they have an interest to keep the value of yen low.

What will happen if the Japanese economy finally makes a confirmed recovery back into normality (there are signs that the Japanese economy may be recovering?read this report)? We can bet that Japanese interest rates will rise, thus putting a squeeze in the carry trade profit margins. More importantly, it means that the Japanese are finally willing to allow their yen to appreciate. Any appreciation of the yen will result in massive reversal of the yen carry trade, which in turn will trigger further appreciation of the yen, resulting in a self-reinforcing feedback loop. The danger right now is that a massive amount of yen are being borrowed (some experts says it is worth a trillion dollars), which in effect is a gigantic bet that the yen will not rise. A disorderly reversal of the yen carry trade will almost certainly mean that there will be losses in terms of billions of dollars, triggering yet another financial crisis. We will then see the collapse of many hedge funds.

The bad news is: This is just the beginning.