How the RBA is Using Low Interest Rates to Destroy Your Wealth

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Apologies to Chris Leithner for using and abusing the title of his excellent book, but The Evil Princes of Martin Place are at it again – they’re fixing the interest rate and creating inflation. We’re calling it the evil pincers of Martin Place, which is where the Reserve Bank of Australia is based.

Glenn Stevens and his fellow cartel members will release their decision on what happens to the cash rate today. Even if they don’t move it, that’s a deviation from a free market price for money.

At least they’ll announce their meddling publicly. Most interest rate manipulation happens in secret these days. Blogger Barry Ritholtz put together a summary of all the news stories of interest rate rigging by banks at his blog The Big Picture. The LIBOR scandal takes the cake, affecting $800 TRILLION in assets directly. Ritholtz also added stories on the price fixing of other financial assets for good measure.

In short, it seems like nothing has an honest price any more.

But, as far as you’re concerned, it’s Australia’s cash rate that’s most important. That’s because it determines your return for ‘opting out’ of riskier assets. How much do you get paid for waiting it out in cash?

Not much, is the answer. And it’s been getting steadily less than that over time. The cash rate is tipped to remain steady today, but has still fallen 2.25% since October 2011. That’s a lot of interest gone missing from your account thanks to the Reserve Bank of Australia. Adjusted for inflation, you’re barely treading water these days.

Of course, most people reckon we’re still the lucky country. Retirees around the world have had to put up with interest rates far lower than ours. In America and Europe, rates have been near 0 for years, and in Japan for almost two decades.

All this means a lot less income for savers. No doubt you’re feeling the pinch of the falling interest rate too, especially when you add in the other half of the pincer, inflation. But then again, that’s the whole point.

Governments and their central banks see interest rates and inflation as a tool. They’re supposed to be an indicator – a price that balances savers and borrowers of money. Instead of balancing, central bankers want interest rates to influence. And you are their number one target.

Right now, central bankers around the world want you to spend your money, not save it. That’s why your reward for saving – the interest rate – is kept so low. They’re trying to goose you into spending more of your money to create economic growth in the form of spending. (Australian retail sales figures for July come out today too, so we’ll see if it’s working.)

But there is a long list of reasons why you shouldn’t give in. The first is a personal reason. The second is to do with the welfare of Australia as a whole.

To understand both reasons, you need to know how central banks actually manipulate the interest rate in the first place.

Just like the private banks who have been manipulating rates, The Reserve Bank of Australia doesn’t just ‘set’ interest rates at 2.5%. It drags them there. To move the rate down, it creates brand new money and adds it to the supply of savings. The problem is, the savings aren’t real – they’re fake. But the new money still influences the interest rate by making more funds available to be borrowed, pushing the interest rate down.

At some point, the economy always realises that fake savings can’t be spent in the future. Instead, the increase in money just shows up as inflation, hopefully just the 2% rate the RBA is trying for.

The combination of missing spending and higher prices is exactly what retirees don’t want. Even if you resisted the temptation to spend your money while your savings earned so little interest, inflation will erode your wealth. And an economy with missing spending is an economy in recession, which usually brings on a falling stock market. In other words, you’re not safe in interest bearing assets like bank accounts and bonds, and you’re not safe in stocks.

So how do you avoid the consequences of the RBA’s low interest rates? In short, you can’t. Unless you think you’re a genius and you swap your shares for cash at just the right moment when the economy figures out it’s been fooled by the RBA’s fake savings and begins to take a turn for the worse.

A more humble option is to own a lot of real assets – tangible stuff. Or diversify so you get the best and worst of both worlds as the cycle plays out.

If you’ve got a patriotic streak in you, you could think about what the economy needs at a time when the RBA is busy buying growth by printing money. And that’s real savings to make up for all the fake printed kind. Savings you’ll spend at some point in the future, creating genuine economic activity.

But the dangers of low interest rates aren’t just about what you should do. It’s also about what you shouldn’t.

Low rates are intended to turn people from savers into consumers, but also into borrowers.

Of all the mistakes you could make when it comes to your retirement or saving for it, going into debt is the most dangerous. It’s the only mistake that can make you lose more than you had to begin with.

To show you what I mean, imagine you borrowed $450,000 to buy a $500,000 home as an investment. If the property price falls 10%, your entire $50,000 deposit disappears. From then on in, you begin to lose more than the $50,000 you started with. The investment didn’t just wipe out the money you put it, it clawed at the rest of your wealth too.

Investments that don’t require debt won’t leave you with a greater loss than your initial investment (with a few exceptions). Even the worst penny stock seldom goes to $0 and hardly any go below that. Although we recall a court case about shares which required holders to pay in additional capital if the company called for it. That might be banned these days.

If you keep in mind that low interest rates are designed to mislead you into making a mistake, you’ll find it much easier to resist the temptation of spending. Hold out against the evil pincers of Martin Place – the interest rate and the inflation.

So what do you do instead? Award winning financial advisor Vern Gowdie has come up with a very drastic answer. But it’s one you need to see.

In The Money for Life Letter one investment we’ve come up with to battle the RBA, in addition to tangible assets, is a certain kind of share. The kind that gives you the best of both interest rates and stocks – capital gains and income. The idea being that you don’t have to rely on both, and you’re likely to get at least one.

We’re talking about dividend paying shares of course. With Australian stocks trading in a 4% range since mid-July, we hope you’ve been collecting some income this reporting season.

In the end, owning shares on the stock market means you own a small part of big companies. So keeping up to date with those companies is crucially important. How have they been going as a group?

Earnings season was ‘all right’ if you ask Australia’s Citigroup analysts. There was a lack of surprises, with earnings falling just short of expectations, but dividends exceeding them slightly. Goldman Sachs calculated that ASX200 companies paid out $54.3 billion this financial year, 6% more than last year.

But payout ratios are being stretched on a historical basis. In other words, companies are paying out a high proportion of their earnings in dividends compared to the past. From here on in, growing dividends will probably need higher earnings.

Of course, it’s impossible to escape the pincers of Martin Place completely. Your cost of living goes up and all the interest rate manipulation weakens our currency market too.

Then again, the Australian dollar looks steady around 90 cents at the moment. But the RBA thinks the currency is still too strong so even if they leave rates alone they’ll probably try to talk the dollar down more in today’s interest rate announcement.

Australian trade figures are out today as well. Our little sister is busy linking trade, currencies and capital flows for her high school economics exam at the moment. We’ll ask her what it all means and let you know tomorrow. The beauty of exams is you have to come up with a definite answer, as plausible or implausible as it may be.

Regards,

Nick Hubble+
for The Daily Reckoning Australia

Join The Daily Reckoning on Google+

From the Archives…

Is a 50% Market Decline Possible?
30-08-2013 – Greg Canavan

Why The 30/20 Tax Rule May Rise Again
29-08-2013 – Vern Gowdie

The Investment Industry: Confusion, Conflicts and Cash
28-08-2013 – Vern Gowdie

The Federal Reserve’s Crucial Next Step
27-08-2013 – Greg Canavan

Superannuation Overtakes Bank Deposits
26-08-2013 – Greg Canavan

Nick Hubble
Nick Hubble is a feature editor of The Daily Reckoning and editor of The Money for Life Letter. Having gained degrees in Finance, Economics and Law from the prestigious Bond University, Nick completed an internship at probably the most famous investment bank in the world, where he discovered what the financial world was really like. He then brought his youthful enthusiasm and energy to Port Phillip Publishing, where, instead of telling everyone about The Daily Reckoning, he started writing for it. To follow Nick's financial world view more closely you can you can subscribe to The Daily Reckoning for free here. If you’re already a Daily Reckoning subscriber, then we recommend you also join him on Google+. It's where he shares investment research, commentary and ideas that he can't always fit into his regular Daily Reckoning emails.
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