Rates are going to be higher than we're used toMichael...

Rates are going to be higher than we're used to

Michael Stutchbury From: The Australian March 18, 2010 12:00AM


THE Reserve Bank may still pause a month before again lifting interest rates towards "normal" levels. But the bigger story is that the normal interest rate for borrowers is likely to be higher than we're used to.

Governor Glenn Stevens is heavily influenced by the notion set out by late 18th century and early 19th century Swedish economist Knut Wicksell that the economy's natural interest rate is set by the rate of return on investing in physical capital.

For Australia, one of the best summary indicators of this is the terms of trade. This ratio of the price Australia receives for its exports to the price it pays for imports spiked spectacularly in 2007 and 2008 in line with sharply higher iron ore and coal price contracts.

The big news is that the post-crisis terms of trade slump is reversing as the spot prices for iron ore and coal have rebounded on the back of Chinese demand. The Reserve Bank has "revised up significantly" its terms of trade forecasts. They could even return to pre-crisis peak levels by the end of the year.

That means bigger profits from digging up Australian iron ore and coal, which in turn is attracting investment into physical mining capacity. The minutes of the Reserve Bank's March 2 board meeting noted "expectations for mining sector investment pointed to further increases from current already high levels". Even though not all mining projects would proceed as planned, they were still likely to keep overall business investment at "very high levels in coming years".

How high? At 16 per cent of gross domestic product, business investment is already at its highest level since the 1960s. The Reserve Bank analysis suggests it is set to rise further to 18 per cent of GDP as the $43 billion Gorgon liquefied natural gas project cranks up.

The Wicksellian analysis suggests that borrowed money will flood into higher-returning investments if the actual or market interest rate is kept below the natural rate of interest set by the returns on such physical capital. That would pump up the economy beyond full capacity and set off inflation.

This natural interest rate is much the same as the Reserve Bank's "normal" or "neutral" interest rate concepts. The central bank is now talking more about returning to the "average" level of interest rates over the past decade or so. It wants to get rid of its monetary stimulus before debating whether the new normal interest rate has been driven higher by an investment boom set off by the elevated terms of trade.

However, assistant governor Philip Lowe referred to the concept this month, saying: "Given that countries with relatively high returns on capital typically have relatively high real interest rates, it should not be surprising that interest rates in Australia are above those in other countries where the return on capital is currently much lower."

For example, the US Federal Reserve yesterday again committed to keeping its official interest rate at "exceptionally low" levels for "an extended period". As Lowe pointed out, even with zero official interest rates, business investment in the US is barely strong enough to offset depreciation.

The Reserve Bank is signalling that it has two or three more 25 basis-point increases in its cash rate, now at 4 per cent, before it gets bank lending rates back to their average levels by the end of the year.

But it almost certainly will have to lift its cash rate more than that to get lending rates back, first to their higher new "normal" or neutral levels and then more again to stop the economy overheating by tightening monetary policy. The cash rate could reach and even exceed the pre-crisis 7.25 per cent peak.

The mining boom can be likened to an approaching economic tsunami. The warning signs are getting louder each day in the business pages. But the broader political debate won't be fully engaged until the tsunami pushes the economy to full capacity. This will come as a shock to those parts of the economy that aren't booming. Because the economy's downturn was so mild, it has less spare capacity than previously expected. At the same time, it has to accommodate the mining investment boom -- worth an extra two percentage points of GDP a year -- plus a wave of public infrastructure projects and a pick-up in housing construction.

The economy can only grow so fast before it spills into higher inflation.

One of the key areas to give will be consumer spending. Access Economics forecasts that real retail sector spending will average only 2.5 per cent annual growth in the five years to 2013-14, down from 3.4 per cent in the previous five years.

Strong demand for labour means consumers will remain confident about the future.

But higher interest rates generated by the higher returns to investing in Australia's mining sector will both eat into household disposable income and encourage consumers to concentrate on reducing their debts.

http://www.theaustralian.com.au/news/opinion/rates-are-going-to-be-higher-than-were-used-to/story-e6frg6zo-1225842054052