Finance 101 – Monetary Policy
To understand what the neutral interest rate is, we need to revisit the basics of monetary policy. Most countries have a central bank (ours is called the Reserve Bank of Australia), which uses interest rates and other mechanisms to determine how much money is in the financial system. Monetary policy relates to the positions of a central bank, and has a range of implications for investors.
Monetary policy can be stimulatory (accelerates economic growth), contractionary (decelerates economic growth) or neutral (neither stimulates nor contracts economic growth). When a central bank lowers interest rates, borrowing money becomes cheaper and spending tends to increase. When a central bank raises interest rates, spending tends to decrease as borrowers have to pay more interest on their debt. In theory, a central bank can smooth out the economic cycle by providing stimulus during downturns and pulling in the reins when the economy is booming.
Unfortunately, economic theories usually don’t pan out in the real world. Many argue that central banks have made the economic cycle worse. For example, the boom in the American residential property market in the early 2000’s, which sowed the seeds for the Global Financial Crisis, was in large part thanks to the Americas’ central bank (the Federal Reserve) keeping interest rates too low in response to the bursting of the dot-com bubble and 9/11. Likewise, the enormous surge in Australian property prices is mostly thanks to the Reserve Bank of Australia keeping interest rates at historic lows, and we will see whether the current decline in prices will cause a recession.
For investors in shares and bonds, generally speaking lower interest rates are good for short term performance while higher interest rates are bad for short term performance. We’ll save the story of how interest rates affect long term returns for another day!