Do we get the interest rates that we deserve?
Could it be that the current ultra-low level of interest rates in Australia has more to do with the familiar levers of supply and demand than as a result of the dire state of our economy?
It is an intriguing and important question that is gaining some traction after research from the Reserve Bank and others has started to point to Australia’s demographics as being an important contributor to our current low rates.
The basic premise holds that Australia’s big demographic bulge of Baby Boomers also hold much of the cash and assets and as they approach or enter retirement, they need to invest their superannuation and other savings to generate a living wage.
To do that safely and provide for their regular spending needs in retirement, they also need to hold a substantial amount of cash or cash-like investments such as bonds or mortgage trusts.
That means the “supply’’ side of the equation is relatively over-supplied, compared to previous generations which were not as large and did not live for as long.
Demand for loans declining as well
At the other end, the demand side, many millennials are forming family units and buying big assets such as homes and cars much later and less often than previous generations.
That leaves demand for loans lower than it has been traditionally, even though there are still twice as many dollars in Australian loans outstanding than there are on deposit.
The effect is global as well, with similar issues being felt in other countries also putting downward pressure on interest rates, lowering global rates and also causing Australian rates to fall.
When supply rises and demand falls, prices must come down
So, what happens in a classical economic system when there is a relative supply glut and decreased demand?
The same thing as when a fish merchant has a big catch to sell and not many people want to buy the fish.
It is simple really, the price goes down and in the case of money the price is the interest rate, which is now hovering closer to zero than ever before now that the official RBA cash rate is a tiny 0.75%, with the possibility that it could be cut again next year a very real proposition.
Wealth being transferred to younger generations
Another way of looking at this is as a means to transfer some wealth to younger generations, other than the traditional one of waiting until the previous generation die off.
The Baby Boomers are price takers – they must accept whatever the market decides for the cash portion of their investments – while the younger generations will find it becoming easier and cheaper to borrow the money they need to start building up assets.
Because they have time on their side, they can also take more risks than the Baby Boomers, meaning that they can borrow money for a wide variety of items ranging from the more traditional “family home’’ through to shares, investment properties, cars and more discretionary items like holidays and technology.
Sure, high property prices make the traditional route of buying a property more difficult but even there the millennials and the other younger generations have time on their side, given the Boomers will eventually be forced by infirmity, the cost of aged care and of course, death, to reduce their property holdings.
Demographics alone can cut interest rates by 4%
Reserve Bank Governor, Dr Philip Lowe, has pointed out that internal RBA research estimates that demographic change will cause interest rates to be 4% lower by 2050 compared with the 1950’s when many Baby Boomers were born.
Speaking to a parliamentary committee recently, he said:” While we might wish it were otherwise, it is difficult to escape the fact that if global interest rates are low, they are going to be low here in Australia too.”
“When the global appetite to save is elevated relative to the appetite to invest – as it is now – interest rates in all countries are affected.”
The RBA research found that slowing population growth in advanced economies due to falling fertility rates, increased life expectancy, higher workforce participation rates and delayed retirement had also played a part.
When you combine all of these trends, the RBA estimates they have caused a 3% fall in interest rates between 1950 and 2000, with a further 1% fall to come by 2050 – independent of whether the cash rate has been moved up or down to dampen or stimulate the economy.
Another change is coming
Of course, the other demographic change that is coming is that the bloated size of the Baby Boomer generation will fall over time as more of this generation die, albeit at an older age than their parents.
In the US, Millennials are thought to be on the cusp of surpassing Baby Boomers as the largest living adult generation.
A report by Pew Research last year said it expected Millennials to overtake Boomers in population in 2019, with Generation X projected to pass the Boomers in population in 2028.
That research defined millennials as aged 20 to 35 in 2016, with Boomers aged 52 to 70 and Generation X aged between 36 to 51.
That will provide a switching point for spending and ultra-low interest rates will be a great assistance for these younger generations in forming households and buying investments and consumer products.
The situation is similar here in Australia, with our high immigration rates also producing a tailwind to generational change.
So next time you hear a Baby Boomer complaining about the low interest rates on their savings, it might be time to point out that they are helping to get younger generations established – whether they like it or not.