Save more or work longer to realise your retirement spending dreams, says Andrew Gawith. Do you agree?

By Andrew Gawith*

The long decline in interest rates is coming to an end.

That may seem an heroic forecast but it's almost a physical certainty - in some countries they are so close to zero that the mattress is a logical alternative.

Interest rates around the developed world are closer to zero than at any time in a generation.

For instance, the US 30-year government bond which is currently yielding around 2.7 per cent was last at that level in the 1950s - in the aftermath of the Great Depression.

In New Zealand you have to go back to the 1960s to find bank deposit rates as low as they are now.

The downward trend in interest rates for many developed economies began in the late 1980s, as monetary authorities got serious about stamping out inflation that had ballooned in the wake of the oil crises of the 1970s.

New Zealand came late to that process but made up for lost time by implementing a particularly effective Reserve Bank Act with a firm focus on low inflation.

By the mid 1990s inflation in the developed world was in the 0-3 per cent range and in New Zealand below 2 per cent.

Our five-year government bond yield, which had been around 16 per cent in 1987 at the height of the Rogernomics revolution, had fallen to just over 7 per cent a decade later.

In New Zealand, and many other economies, the steady decline in interest rates meant people could service larger mortgages which banks were very willing to provide - even to the extent of foregoing any requirement for borrowers to post a deposit.

The consequence was a big lift in household debt and a boom in property prices.

House prices here rose 45 per cent over the five years ended March 1997.

In the US they rose substantially over the late 1980s and again between 1998 and 2006, when they increased by a whopping 200 per cent on the back of some pretty loopy lending practices that eventually helped trigger the global financial crisis.

Spain's current financial turmoil can be sheeted home to a similar bout of delinquent lending to the property sector which is now in full retreat.

The big downswing in interest rates is coming to an end; most countries have run out of scope to cut short-term interest rates further.

So the question is when will rates begin to rise again?

The leveraging cycle has been slammed into reverse, stunting economic growth and forcing central banks to print money to keep credit markets from freezing.

The historically low interest rates and easy access to credit, particularly in the US, is intended to kick consumers, businesses and the economy back to life.

If that occurs, demand for credit is likely to pick up and with it interest rates.

Higher inflation could also emerge and that would also spur an uptick in interest rates.

However, the Federal Reserve (the US's central bank) has made it clear that it doesn't expect to raise short-term interest rates until at least 2014.

Even our own central bank keeps putting off any increase in the official cash rate - it's now talking about 2013.

Australia has recently cut their official cash rate. So there are no compelling signs of a rise in interest rates this year.

But could the current low growth, low inflation, low interest rate environment be a medium-term phenomenon?

That is, should we really expect to come out of the present economic fug this decade?

Let's consider Japan's experience of the last 25 years.

In the late 1980s, Japan experienced an asset price bubble that at one stage had the land surrounding the Imperial Palace in the heart of Tokyo valued at more than the entire state of California.

When the bust came it crippled the banking sector, the economy, the share market and even disfigured the almost perfect labour market.

All very unpleasant, but far more disturbing has been the legacy of the boom and subsequent bust.

Since 1990, Japanese economic growth has averaged about 0.7 per cent per annum (interestingly when translated into growth per capita, it's nearer 1 per cent per annum - just a little slower than Germany's per capita growth over the same period of 1.1 per cent per annum).

More significantly, inflation over the past two decades in Japan has oscillated around zero and interest rates have hovered just above zero for most of that time.

Might this be the shape of things to come in Europe and America for the next decade?

While there are obvious differences between Japan's economy and those of Europe and the US, it's less obvious that Japan's experience can be ignored as a warning for other developed economies.

The message to households around the developed world is that the party of the last two or three decades is over and the bills are now coming in thick and fast.

Governments may be able to stall payment for a while, but ultimately households will have to pay for the party.

That reality is already translating into restrained consumer spending and more savings.

That's what Japanese households have been doing for a decade or more and the effect has been to limit economic growth and inflation and thus keep interest rates low.

So while cash rates aren't likely to go much lower - because for many countries they simply can't - they're so close to zero that the current low growth, low inflation and low interest rate environment may last a lot longer than most of us have been assuming.

That's what investors in US 30-year bonds are now telling us.

We might have to get used to lower investment returns, which could mean having to save more or work longer to realise our retirement spending dreams.

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Andrew Gawith is a director of Gareth Morgan Investments.
This piece was first published in the NZ Herald. It is used here with permission.