Weekly economic update: When cutting interest rates might not help

It is thought that it doesn’t help much to cut official interest rates toward or beyond zero, and maybe it doesn’t, but new research suggests the answer has a lot to do with the housing market, writes …

Richard Holden, UNSW

There’s a meme around official interest rates since the financial crisis, and it goes like this. 33719931_l

Central banks have already cut them to nearly zero (or actually zero) but advanced economies are still languishing.

Therefore cutting them further won’t achieve much.

There are a number of problems with it.

One is that it’s a nice illustration of the post hoc ergo propter hoc fallacy – “after this therefore because of this”.

It ignores the counterfactual.

Maybe we would have spent a decade in severe recession had it not been for the interest rate cuts.

But there might also be a grain of truth to the idea that cuts don’t do what they once did.

It has led to a whole cottage industry exploring the “channels” through which cutting interest rates is meant to work.

Mortgage refinancing matters

One potentially important channel is through refinancing of mortgages.

When interest rates drop it can be attractive for mortgage holders to refinance, take out some equity and spend it. 

investor-enquiry-form

This was a particularly big deal in the United States in both the run-up to, and the aftermath of, the financial crisis.

It has also been a big deal here, where refinancing is easy and for the last few decades many borrowers have had mortgage offset accounts.

A recent paper, now forthcoming at the Quarterly Journal of Economics (the highest-ranked journal among all the social sciences), examines the channel using data from across the United States.

The authors, from the University of Chicago, MIT and the Swiss National Bank, begin with the following fact.

During the financial crisis there was a big drop in US house prices, but the drops were especially severe in places like Las Vegas and Phoenix.

By contrast, in the previous (2001) recession house prices continued to grow across the country with little regional variation.

This means there were regional variations in embedded equity in one recession but not in the other.

Which means house prices matter

So far that’s just a mundane fact of US financial history. But the authors observe that to refinance a loan lenders typically insist on a minimum level of equity – a loan-to-value ratio – which gets recalculated.

That means they weren’t surprised to find that the sharp interest rate cuts in 2008 had the smallest effects in the most economically depressed parts of the country.

Put another way, they had the smallest effects where they were needed the most.

Australia doesn’t have much negative equity, yet.

But in one city (Sydney) prices are falling faster than elsewhere.

And negative gearing matters

A complication is that Australia allows “negative gearing”, the practice of renting out properties for a tax-effective loss and then selling them in an appreciating property market for a lightly taxed capital gain. Negative Gearing

Rather than refinance for consumption, plenty of Australians have been refinancing to buy and negatively gear investment properties.

But when prices fall that strategy no longer makes financial sense, pushing the buying of investment properties for negative gearing to a grinding halt.

This amplifies the fall in prices.

In essence, negative gearing acts as a multiplier in the property market on the way up and on the way down.

Right now, we are seeing the “down” in certain parts of Australia.

Which means it matters where you live

You’ve got to feel for central bankers, at least a little bit. RBA

Not only do they have to worry about employment, economic growth, the exchange rate and housing prices, they now also have to worry about how their interest rate decisions are affected by regional variations in the history of house prices.

Still, understanding the precise channels through which changes in interest rates affect real economic activity is crucial to determining good policy – and predicting what the Reserve Bank will do next.The Conversation

Richard Holden, Professor of Economics and PLuS Alliance Fellow, UNSW

This article is republished from The Conversation under a Creative Commons license. Read the original article.



icon-podcast-large

SUBSCRIBE & DON'T MISS A SINGLE EPISODE OF MICHAEL YARDNEY'S PODCAST

Hear Michael & a select panel of guest experts discuss property investment, success & money related topics. Subscribe now, whether you're on an Apple or Android handset.

 

NEED HELP LISTENING TO MICHAEL YARDNEY'S PODCAST FROM YOUR PHONE OR TABLET?

We have created easy to follow instructions for you whether you're on iPhone / iPad or an Android device.

icon-email-large

PREFER TO SUBSCRIBE VIA EMAIL?

Join Michael Yardney's inner circle of daily subscribers and get into the head of Australia's best property investment advisor and a wide team of leading property researchers and commentators.


Avatar for Property Update

About

Apart from our regular team of experts, we frequently publish commentary from guest contributors who are authorities in their field.


'Weekly economic update: When cutting interest rates might not help' have no comments

Be the first to comment this post!

Would you like to share your thoughts?

Your email address will not be published.
CAPTCHA Image

*

facebook
twitter
google
0
linkedin
0
email

Michael's Daily Insights

Join Michael Yardney's inner circle of daily subscribers.

NOTE: this daily service is a different subscription to our weekly newsletter so...

REGISTER NOW

Subscribe!