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Reserve Bank's hit to retirees and first home buyers is all part of the plan

Jessica Irvine

Before he hurtled off on a well-deserved, post-retirement holiday – driving a rented white convertible Mustang down Route 66 – former Reserve Bank of Australia governor Glenn Stevens spent much time pondering the financial fate of fellow retirees.

While home borrowers might be cheering his legacy as the man who dropped interest rates to record lows, the governor was frequently the recipient of angry letters from retirees relying on dwindling interest payments to fund their retirement.

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Glenn Stevens: The exit interview

The RBA governor reflects on a turbulent decade as he prepares to leave the top job.

In one of his final speeches, Stevens acknowledged lower interest rates were a "big problem" for many retirees and that many would end up "disappointed" with their nest eggs. 

While the media have a tendency to celebrate interest rate cut savings for mortgage holders, of course for many Australians with savings in the bank, interest rate cuts leave them worse off.

This has led many to question whether rate cuts simply steal from savers to boost borrowers. Do interest rate cuts really work?

Firing back, a discussion paper released by the Reserve just before Christmas has delved into the numbers to quantify if rate cuts really boost spending overall, once the negative impact on savers is taken into account.

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Of course, there are other ways that lower interest rates stimulate the economy, aside from putting more cash in some people's pockets.

Wealth effect

Lower interest rates increase the overall incentives to consume now versus save for later, by making borrowing cheaper now and reducing the return on savings – this is what economists call the "intertemporal substitution" channel of monetary policy.

There is also the "wealth effect" for home owners because lower interest rates generally pushing up house prices, making them feel wealthier and more likely to spend.

Lower interest rates also generally mean a lower currency, boosting the economy by helping exporters and making imports more expensive, thereby increasing consumer's desire for domestic goods and services.

All these ways in which lower interest rates influence aggregate demand in the economy are known as the "transmission channels" of monetary policy.

Arguably the most important channel, however, is known as the "household cash flow channel" – the hip pocket impact of interest rate changes.

In Shakespeare's play Hamlet, Polonius advises his son Laertes to: "neither a borrower nor a lender be".

In reality, most Australian households are both.

Nation of borrowers

About two-thirds of Australian households have some form of debt. About a third have a mortgage (another third rent and another third own their homes outright) making them often significant borrowers.

And, whether they know it or not, many Australians are also lenders. If you have money in a term deposit or savings account, you are effectively lending that money to a bank in return for interest payments.

Of course, these lenders are squeezed when interest rates fall. But borrowers benefit. So who benefits most? Do interest rate cuts put more money into the pockets of households, and do they actually spend it?

To answer these questions, the RBA researchers drew on data from the biggest longitudinal survey of Australians – the Household Income and Labour Dynamics In Australia survey.

Among many other things, the survey tracked the spending patterns of households during the sharp drop in interest rates at the onset of the global financial crisis.

Researchers were able to compare the spending reactions of households on variable interest loans against those on fixed interest rate loans – thus isolating the impact of lower interest payments.

As it turns out, many variable-rate borrowers simply took the cash saving from lower rates and repaid their mortgage faster.

Spending durability

For every dollar in interest saved, borrowers diverted about 70¢ into higher mortgage prepayments, 16¢ on buying durable goods and 14¢ into other forms of saving.

So while much of it did go into saving, mortgage borrowers did increase spending in response to lower interest rates.

Interestingly, spending on durable goods – such as  cars, computers, fridges and furniture – is found to be more responsive to interest rate changes. Spending on non-durable goods, such as groceries, clothing and healthcare is less responsive.

On the flipside, lender households – those earning interest payments from banks – were found to be less responsive to extra interest income. If incoming interest payments were boosted by one dollar, they were found to only increase their spending by 5¢.

Overall, the researchers concluded that every 1 percentage point cut in interest rates would increase household spending in the economy by between 0.1 and 0.2 per cent.

There are roughly equal numbers of borrower and lender households in Australia.

But the debts of indebted households are much bigger than the savings of lender households, leaving them much more sensitive to changes in lending rates.

Murky picture

On average, Australian households were found to hold an average of $53,000 in interest-earning liquid assets but nearly $128,600 in interest-sensitive debt. In net terms, the average Australian household is a borrower.

Interestingly though, when you look at the median or "typical" household, a different picture emerges. The typical household does not have a mortgage and holds more interest-earning liquid assets than debt. The median household is a net lender. Perhaps that's why there is a broader outcry against interest rate cuts than the newspaper case studies of happy mortgage families would suggest.

Turns out, the number of borrower and lender households in Australia are roughly equal.  Of course, most people are a bit of both – a bit of cash in the bank and a few loans. But the number of net borrowers – whose debts exceed their savings – is about the same as the number of net lenders – whose savings exceed their debts.

Who are they?

Well, borrowers tend to be middle-aged people paying down a mortgage.

"The average borrower is younger, earns more income and is almost twice as likely to be in the workforce as the average lender."

Lenders tend to be young people saving for a deposit or older people living off the income stream of their saving (plus whatever pension they are entitled to).

Overall, interest rate cuts do end up boosting domestic demand in the economy. But they don't hit everyone equally.

Monetary policy is effective in achieving its goal of influencing domestic demand, but the way it does so is not necessarily fair.

There is not much the Reserve Bank can do about that – it only has one policy lever. It falls to governments to be mindful of the impact of interest rate changes on retirees, mortgage holders and first home buyers and to set other policies accordingly.

Nevertheless, Steven's successor, Phil Lowe, should brace for more angry letters from retirees this year.

Ross Gittins is on leave.

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