Australia's 'weak' economy on brink of 'lost decade'

Australians live in a time of low interest rates, low wages growth and low inflation, and they keep thinking this is an aberration.

They talk about "normalisation", expecting the lines on the graphs to soon turn and rise up again. It's time to consider the alternative. That this is normal — the new normal.

A lasting era of low interest rates, low wages growth and low inflation would change Australia. Low interest rates mean borrowing large sums of money will be much easier than in years past — that could push house prices up.

But with low wages growth and low inflation, paying back large sums might be a lot harder.

That matters a lot for a country with record levels of household debt.

Maybe Australians should have seen this coming. After all, big shifts in the level of interest rates and inflation are not unprecedented. Mortgage interest rates fell from about 16 per cent to 5 per cent over the past 30 years. Is a further fall to three-point-something really so unimaginable? Inflation fell from over 17 per cent in the 1970s to a stable 2 to 3 per cent more recently. Perhaps seeing it fall to 1.3 per cent is not so surprising.

What sort of world would Australians live in if their situation continues? One answer can be found if you go north: Japan.

The lost decade

Japan's economy has been stuck in a rut of low growth, low inflation, low wages growth and low interest rates for a long time. They call it "the lost decade" but the sad truth is it's actually two decades now — they first cut rates to 0.5 per cent in 1995.

Japan was once like a vision of the future — all neon and robots. That has faded. Now going to Japan feels like going back in time — lots of cathode-ray TVs, shops that only take cash and real estate that hasn't had a renovation since salmon pink was in vogue. Its economic weakness is tangible. House prices fell for 15 years.

Japan's economy has been growing though. And unemployment is fairly low. It is not in acute crisis like the global financial crisis. Just an ongoing insufficiency it hasn't been able to solve with policy. Which, if you think about it, sounds rather a lot like what's happening in Australia.

Low interest rates have not been enough to solve Japan's problems. It's worth thinking about why that is.

Why do interest rates exist?

Interest rates exist because of something called the "time value of money". Humans are naturally impatient. Would you rather have $100 now or $100 next year? That's an easy question for most people: Now!

Because we prefer money now, we require compensation if you'd like to borrow our money, and we will pay to borrow money. That's why banks exist.

Different people have a different time value of money.

Would you prefer $100 now or $102 next year? This is the question your savings account asks you. When you save money in the bank and get 2 per cent interest, you get $102 next year instead of having $100 to spend now.

If you choose not to save, it's because that extra $2 is not enough for you. In fact, you might want money now so much you're willing to borrow.

Banks know they can lend some people $100 now and they will be willing to pay back more next year — perhaps $104 (for example).

With the low level of interest rates, it is much cheaper for Australians to borrow. This is great news for the people whose time value of money means they want money now. And bad news for savers.

Which is precisely the point. The Reserve Bank of Australia (RBA) is trying to get people to borrow and spend. They want Australians to borrow from the future to spend up big and make the economy buzz with activity.

The problem is that Australians don't always spend on the things RBA want them to spend on. They invest little in business and much in housing.

And if the low interest rates don't make the economy spark to life — then they can be stuck in a cycle of low inflation and low interest rates.

However, Australian rates are not that low

While official interest rates in Australia might be sinking fast, a new analysis published in The Australian points out the actual interest rates on mortgages are reacting slightly differently.

Banks have not passed on the full interest rate cuts of recent years. As the below graph shows, standard variable mortgage interest rates (the red line) used to sit just above the cash rate (the blue line), but as that blue line has fallen the red line has not fallen so much.

Interest rates have been falling, but the banks haven't been keeping pace. Photo / Supplied

The difference between the standard variable rates and the official cash rate is now at its highest level in decades, as the next graph shows.

If the gap had stayed stable, Australians would be paying thousands of dollars a year less on the mortgage.

The gap between official rates and bank rates is getting bigger. Photo / Supplied

But it's not as simple as the banks being greedy. Banks are profitable, yes, but they are no longer making record profits. Part of the problem they face is they still need to get deposits in the door.

They have to pay at least some money to savers, and the official interest rate is very low. One per cent interest doesn't sound tempting when inflation is above 1 per cent. So banks must these days pay interest rates higher than the cash rate to savers.

That said, those savings rates have been slashed too. A term deposit may still get you an interest rate above 1 per cent — but not much above.

It's all part of the same downward trend — lower interest rates, lower inflation and lower economic growth. And Australians might have to get used to it.