One of the fundamental intents of the record low interest rates that have been adopted in advanced economies over the past decade is encouraging people to spend now rather than save for later.
Interest rate cuts put extra cash in the pockets of home owners by reducing their mortgage payments. This means they’ll probably start making some extra purchases they otherwise couldn’t afford. This boosts activity in the consumption component of the economy, which involves you and me out buying goods and services. In most advanced nations it’s well above half of all economic activity.
The other intention of super-low interest rates is encouraging businesses to invest more money. All other things being equal, a business plan that requires borrowing a truckload of money will be more profitable over its lifetime. And business investments generally create jobs, further helping along the consumption component of the economy.
All that extra borrowed money washing around tends to increase demand – and therefore the price – of a lot of things. There has been a great deal of analysis on how record-low interest rates have inflated stock prices, because investment funds facing returns below 1% with cash they hold in the bank have little option but to put at least some of those huge amounts of money into stocks.
And in Australia, as interest rates have tumbled to a record-low 2% from just over 7% back in 2008, we have seen the impact on the housing market. Cheap money has been the biggest contributing factor to the run-up in house prices around Australia over the past five years.
All quite simple. But there is a dark flipside that is now coming into focus: this is all potentially ruinous for the future financial position of today’s young people.
This is starting to become a topic of conversation because, as things stand, it does not look like there will be a return to a period of even medium-level interest rates any time soon.
The reason is simple: today’s young workers simply do not have access to the almost magical effect of compound interest in fattening up savings accounts over time. Here are two simple charts to illustrate.
Let’s say at the age of 25, you have $5,000 sitting in your superannuation account – and you pay an average of $600 into it each month for the next 40 years, and your interest rate is at the 7.25% level it was back in 2008.
You end up with $1.8 million dollars! Great.
Now let’s make the same calculation but set the interest rate at the current 2%.
Less than half a million bucks.
Now, of course there are many other things to consider. Unless you are Chicken Little, you will have your retirement savings spread around a bunch of diverse investments, including stocks and some bonds that pay more than cash. But stocks are risky and fixed-interest yields tend to be lower when interest rates are lower.
But there is no denying that people entering the workforce in advanced economies now will be denied an important avenue of reliable wealth accumulation that has been available to generations before them.
RBA governor Glenn Stevens said this week that current notions of a comfortable retirement might start to get out of reach for people over the coming years.
“The implicit promises – even if made only to themselves – about their retirement incomes are in danger of not being fulfilled. It is not a very daring prediction to say that these issues will loom ever larger over the years ahead,” Stevens said.
And they should.
Some people might sound a little alarmist when they talk about low interest rates “stealing from the future”. But it is clear that it is not unfounded.
The simple fact is that the longer interest rates around the world remain at their record-low levels, the harder it will be for people to save for retirement.
- Glenn Stevens – Low interest rates will ruin your retirement
- Here’s what Australians need to earn to retire with $1 Million in super