The aggressive interest rate cuts from central banks this week will certainly be welcome news for borrowers, but is it really something to cheer about?
Let’s consider the basics. Monetary policy is the primary tool that central banks use to keep the pace of economic growth and inflation at a reasonable level. If the economy starts to grow at an unsustainable pace and inflation starts to become a problem, the Reserve will raise rates. In effect this makes money more expensive and acts to slow things down. Conversely, when the economy looks like it’s in trouble, the Reserve will lower interest rates in an effort to encourage spending and in turn economic growth.
So if you think about the latest cuts objectively, we should probably be a little concerned. Normally rates are moved in quarter percent increments, so the one percent drop was rather exceptional. For Central Banks to make such a decisive move suggests that they must be very concerned indeed about the outlook for the global economy. And well it should - global events are indeed worrying.
The last time we saw a cut in rates of this magnitude in Australia was around 16 years ago when we were in the grip of a recession. The excesses of the 80’s led to a stalling economy, high unemployment and falling asset values. Back then financial companies were also struggling, and indeed Westpac Bank almost went bankrupt after notching up a $1.6 billion loss that year. In short, it was a difficult time for most people. So while it seems like great news that interest rates have dropped, consumers would do well to tread carefully.
Following this week’s rate cut, mortgage holders will now find themselves with a noticeable amount of extra money to spend - a loan of $300,000 will cost $200 less in interest each month. Many people will most likely go shopping with this extra money (retailers are certainly expecting them to), but it would be wise to resist the temptation.
If you are able, the best thing to do would be to maintain your interest payments. This will allow you to pay down your loan at a greater rate, which will in turn lower your interest expense going forward and increase your equity. It might not seem like much, but the extra payments will wipe years off your loan.
Moreover, consumers would do well to watch their spending in general. And while this will be difficult as we approach Christmas, the last thing you want to do in the current environment is live beyond your means. Put simply, if you can’t afford it, don’t buy it! If you absolutely must buy something then do what your grandparents did and save up for it! Even with the cut in interest rates, credit cards still charge rates that will soon cripple you financially if you aren’t careful.
So let’s view the recent interest rate cut for what it is – recognition that we are facing significant financial challenges and an attempt to prevent further economic degradation. Most people will benefit from the cut in lending rates but given the outlook it would be prudent not to squander the extra cash. Indeed, the more savvy consumers would be looking to use the lower lending rates to improve their net position and gain a real advantage.