Interest rates heading into a new era

Australia and the world are entering a new interest rate era.

In Australia, this new chapter is highlighted by a faster than expected fall in inflation. For the world, the biggest signal is the dramatic increase in the buying of US 10 year bonds, which has slashed the yield from around 5 per cent to below 4.3 per cent.

Forecasting the next steps in this new era bristles with hazards, but there are important signposts that are set to become important.

America is engaged in a major spending program directed towards developing better productivity, electrification and more defence equipment.

As long as that spending program continues, then it is hard to see a spectacular fall in US inflation that would drag interest rates back to anywhere near former levels.

In Australia, we are starting to see much greater wage pressures in sensitive industries as an angry workforce seeks to recover at least some of the substantial fall in real income that has taken place in the last few years.

Much of that pressure is now concentrating on government services, commercial building and parts of the transport industry, but it will spread.

The curbing of Australian inflation in the latest statistics will almost certainly at least put a halt to further interest rate rises in coming months.

But Reserve Bank governor Michele Bullock can see the wage pressures mounting and because her interest rate attack on inflation only severely impacts around 30 per cent of the population, the central bank is likely to want to hold interest rates at current levels until there are much greater falls in inflation and the wage push slows.

One of the shocks that is vibrating around the large project building industry is the enormity of the cost rises that have taken place, which are making new projects uneconomic unless there is a strong revenue stream or some unique advantage, like low cost land.

This week I was talking to a major hospital developer who explains that a $100m hospital of a few years ago would now cost $150m and medical charges have not yet risen far enough to enable an economic rent rate to be paid to provide a return on buildings requiring those sorts of construction costs.

Of course governments can simply borrow the money and don’t look for a return, but overtime wherever major private outlays are required, the society will need to have activities that generate the higher income required to match the construction costs.

Right now, politicians, including those in Australia, are embarking on enormous capital investment programs to lower emissions without any regard to the costs.

Accordingly, that means that we have only just started on power price increases without subsidisation.

And within the total interest rate market, there are many private equity and other high leveraged global enterprises that invested large sums to substantially lower costs or to increase profitability.

Many of those enterprises still have debts that will require refinancing in the next 12 to 18 months.

I was recently yarning to Karl Dasher, President of Florida based global asset manager Polen Capital, who believes that despite lower government bond interest rates, a significant number of securities will continue to require higher rates to attract support.

Some of the companies that leveraged and did not achieve their goals will struggle. Others are performing well, but will still be required to pay interest rates approaching 10 per cent in the US and even more in Europe.

Dasher believes these debt securities represent much lower risk than equities but are providing an equity-style return that is well above inflation.

Mining companies like BHP and many others don’t believe the money markets have understood that electrification will require massive investment in new mines and processing plants for copper, nickel, lithium and many other minerals.

With higher construction costs this will translate into much higher power costs which will underwrite inflation, without power subsidisation.

In Australia, bad practices in state and local governments plus an array of taxes adds around 40 per cent to the cost of dwellings.

But there are few signs of state and local governments being willing to change their way of administering to reduce the costs, so longer pain may be required.

Given the federal government is trying to pass industrial relations legislation which aims to substantially increase costs and lower productivity, there is no mood in Canberra looking to force the states into reducing the cost of housing.

It has to come from communities who currently have little understanding of what is taking place.

The traditional global central bank formula to slash inflation is to increase interest rates to a level that brings on a very severe downturn, forcing enterprises and governments to slash their workforces and either stop increasing prices or reduce them.

Around the world, government spending programs and community encouragement are thwarting central banks from achieving their aims. They rarely communicate harsh realities with the public because it would trigger a backlash.

Our Reserve Bank governor Michele Bullock has confessed part of the truth on a couple of occasions and was heavily criticised, so almost certainly will be more careful in the future. Her new deputy understands the rules.

Nevertheless, despite all the problems, inflation has to fall which gives us a good chance to be able to stabilise interest rates in Australia and reduce them in countries where there is a better understanding of what is required.