Fiscal Discipline: Central banks and interest rates

There is an intrinsic interest rate in any market that matches demand for credit with savings. This equilibrium rate fluctuates in a fairly narrow band as demand for credit may increase with major projects; and supply of savings may vary with the attraction of alternatives, such as other investment or increased consumption.

So why does the central bank move rates outside this range?

Economic Cycles

There have always been economic cycles. Prior to the industrial revolution and the advent of central banks there were three major causes:

• crop failure, through droughts, floods, pests and other natural disasters;
• plague which impacted directly on the human population and on productivity; and
• good, old-fashioned war; with lots of cannons, cavalry charges and dead peasants.

More recently, central banks have attempted to alleviate some of the symptoms of these natural disasters but with limited success. Economies are now dominated by interest rate cycles and, in some parts of the world where central banks may lack the usual restraint, by currency crises.

Why Central Banks meddle with interest rates

Central banks are often subjected to huge pressure through the media to maintain low interest rates; from politicians, banks, economists, business and other interest groups. If the economy is flat, economic collapse is predicted and calls for the central bank to reduce interest rates dominate the media. During a boom, if the central bank considers a rate hike, we face constant warnings of imminent financial disaster. 

How should the bank respond?

The primary function of the central bank is to protect the value of the nation's currency. If inflation rises, the bank raises interest rates to cool demand. The effect is a triple whammy:

• higher rates charged on existing debt means that consumers have less money to spend elsewhere;
• consumers also defer purchases of durables because of higher finance charges;
• corporate sales and earnings suffer as a consequence; and, in addition,
• corporate earnings are reduced by the increased cost of corporate debt.

If the central bank wants to stimulate the economy (while not its primary objective, huge political pressure may be applied through the media) it will lower interest rates. If anything, the effect of an interest rate reduction is even more pronounced:

• lower finance charges mean that consumers have more money to spend;
• purchases of durables increase as they attract lower finance costs;
• corporate sales and earnings rise;
• investment increases as feasibilities are prepared with increased sales and lower financing costs;
• stock prices rise as earnings increase;
• investors are encouraged and invest more money in the markets, much of it borrowed at low interest rates;
• this, in turn, fuels further price rises and further speculation.

The Political Pay-off

Reactions to increases and decreases in interest rates are not immediate; consumers and investors take time to change their mindset. The effect of a rate change may only be fully felt more than 12 months after it occurs. Banks, for instance, normally only notice an increase in failures 12 to 18 months after rates have increased.

Politicians love this. They can boost the economy before an election and the side-effects won't appear until a year or two later. Unfortunately, the central bank then has to stand on the brakes to rectify the problem. This is known as the four-year presidential cycle: boom before the elections and bust a year or two later.

The Tax System

Further distortions are created by income taxes that encourage consumers to borrow.

Negative gearing enables taxpayers to write off the finance costs for purchase of appreciating investments (such as property or equity) against their current income. Capital gains from the appreciating assets are only taxed later and normally at advantageously lower rates. Who wouldn't borrow money at low interest rates to buy assets that are likely to appreciate because of inflation (which is fuelled by low interest rates in the first place)? Especially when portion of the finance costs can be recovered from current income.

Some economies such as the US go further, allowing taxpayers to deduct interest paid on their home mortgage from their income. This further fuels demand for residential property over other forms of investment, and distorts the overall market. 

Public perceptions: dangerous lags

If inflation is apparent for any length of time, the public learns to adjust for it:

• wage demands are linked to inflation;
• property rentals escalate with inflation;
• costs of general goods and services rise as supply costs increase;
• investment patterns alter to protect against erosion of capital.

When inflation is entrenched it is very difficult to get rid of. Changing public perceptions is no easy task and the central bank may need to take fairly drastic steps, over a considerable period of time, to cure the economy of this malaise.

Fiscal discipline

Fiscal discipline requires the central bank to maintain rates as close as possible to the intrinsic equilibrium rate. Their hardest task is to withstand the constant political pressure and to act in the long-term interests of the economy.

Fiscal discipline also requires political leaders to ensure that passengers (consumers) are wearing their seatbelt:

• that the tax system does not create incentives to borrow;
• that consumers do not over-borrow;
• that savings are maintained at reasonable levels;
• that banks lend with restraint; and
• that we all don't suffer from constant "whiplash".