Interest rate cuts are not always good news

Relaxing lending standards will start a chain reaction.
Relaxing lending standards will start a chain reaction.

Interest rates are down, with strong hints of more cuts to come. While this has been welcomed by some commentators, I feel it's taking Australia down a very dangerous path.

With rates already at historic lows, a cut from 1.5 per cent to 1.25 per cent will do nothing to stimulate the economy. If a buyer finds a property that's an absolute bargain, does anybody seriously think that 25 basis points will make a difference to their buying decision?

Controlling the economy by manipulation of interest rates is a tool that has passed its use-by date. Monetary policy is like a strong drug: highly effective in big doses in the early stages, but as the doses become more extreme the effect wears off. Interest rates are now so low that any changes can make little difference to the economy.

But what the cuts will do is lure homebuyers into what may be a nightmare journey. It begins as they stretch themselves to achieve the dream of a first home at a time when rates are at historic lows. But eventually rates must start to rise again.

To make matters worse, before the election the government announced plans to let first home buyers into the market with just 5 per cent deposit. And to add fuel to the fire, last month APRA instructed lenders to ease up on eligibility criteria.

Let's have some straight talk. The global financial crisis was born when President Bill Clinton instructed mortgage lenders in America to reduce lending standards so that poorer people had a chance of home ownership. Consequently, hundreds of thousands of Americans were lured into buying homes they couldn't afford, and most of them lost what little they had. During the slump the median price of a home in Detroit, Michigan fell to just $7500. Is this the example Australia wants to follow?

Relaxing lending standards will start a chain reaction. The number of first home buyers jumps, the extra demand pushes up house prices and it becomes even harder for young couples to get a foothold in the housing market. As prices rise, and affordability worsens, other potential buyers who are saving for a deposit panic and rush into the market, creating a boom.

Now the dream has turned to nightmare. The final step in the cycle is interest rates rising, homes being foreclosed and housing prices falling, or at least staying flat.

It will be mixed news for retirees. Australian shares are sure to rise as they become relatively more attractive than term deposits, especially now that the threat to franking credits is over. And any drop in interest rates will put further downward pressure on the Australian dollar, which will make international investments worth more, at the same time as it puts up the cost of imports.

But the people who will suffer most will be age pensioners, many of whom who are scared of growth investments, and who are subject to the deeming rates, which assess income-tested pensioners on the assumption that they are earning a specified return on their investments.

The deeming rates for a couple are 1.75 per cent on the first $85,000 of financial assets and 3.25 per cent on the remainder. These rates are unobtainable for bank deposits.

Treasurer Josh Frydenberg has already warned the banks that they will be in serious trouble if they don't pass on the rate cuts in full to borrowers. Obviously, most of the banks will obey, but the quid pro quo is that they will extend the rate cuts to the deposits as well. So the government should reassess the deeming rates as a matter of urgency. The Catch 22 is that any cut in the deeming rates will give a pay rise to income tested pensioners, which means a further hit to the burgeoning welfare bill.

  • Noel Whittaker is an Australian expert on personal finance and the author of Making Money Made Simple. Send your money questions to noel@noelwhittaker.com.au.