This article was originally written and published by Openly Investing.
“I’ve never responded well to entrenched negative thinking” – David Bowie
In the corridors of the Reserve Bank of New Zealand (RBNZ), an important discussion is rumbling on to the beat of drums. The topic of these discussions is squeezed into the column inches of the financial press and could easily be overlooked. But the ramifications of these musings – were they to become a reality – should not be underestimated.
The topic, negative interest rates, is most certainly a possibility but is it a probability?
Central banks have many weapons in their arsenal that it may wield to either stimulate or constrain economic activity. With COVID-19 having derailed the world’s economies to present all of us with a synchronised global recession, central banks – alongside their respective governments – have moved aggressively to promote a recovery. Indeed, the RBNZ has lowered the Official Cash Rate (OCR) to a record low of 0.25%. This type of policy (monetary) is typically accompanied by government stimulus through additional spending (fiscal) initiatives and even adjustments in regulation designed to encourage activity.
Why would the RBNZ desire negative interest rates?
The flow of money through an economy is critical in providing the activity that is the lifeblood of growth and this is bolstered by the banks who lend to both individuals and businesses. However, the lending process can sometimes stall as banks move to strengthen their balance sheets against existing loan losses by hoarding money. Negative interest rates are designed to challenge this situation by encouraging lending as an alternative to being charged a penalty for depositing their excess cash at the RBNZ.
Whilst the prospect of negative interest rates in New Zealand is a recent concept, it is by no means new on the global stage. For many years, conventional wisdom held that negative interest rates could not occur. However, in more recent times, central banks in both Japan and Europe have operated negative rates in an attempt to raise both economic activity and inflation. Indeed, The Bank of Japan (BOJ) has positioned their official cash rate close to zero or below for much of the past 20 years, whilst the European Central Bank (ECB) has facilitated the same situation since July 2011.
But does it work?
Despite these long periods of zero to negative interest in both Japan and Europe, their economies have continued to exhibit sub-par growth and with it, inflation. Whether this lacklustre economic activity is entirely related to the failure of this unconventional interest rate policy is difficult to ascertain with any real certainty, given there are many other factors that affect their economies at play. With the ambiguity of the results clear, detractors of the strategy are provided with ammunition with which to oppose such a move in policy, which has also been backed up by one of the world’s most powerful central bankers, the US Federal Reserve’s Governor Powell. Recently, he stated that negative interest rates “could interrupt the well-known process where banks take funds from depositors and lend them out to borrowers” whilst adding “that the evidence of the effectiveness of such measures is mixed.”
Why might this be?
As we have discussed in other writings, economic activity, prices, consumer spending, house prices etc. are all reliant on confidence – both present and future. Lower interest rates are designed to boost confidence through lower borrowing costs, which in turn leads a business to invest in itself or a consumer to shop. However, the spectre of negative rates may be a step too far in the bolstering of confidence and have the opposite effect. Indeed, a move to negative rates may suggest the economic backdrop and outlook is so poor that neither businesses nor consumers will see the time as right to spend or invest.
In addition to potentially derailing any stimulus that such a policy was designed to achieve, negative rates could also impact the very banks it is encouraging to lend. Bank lending is backed by deposits from companies and individuals alike and in New Zealand, some 80% of this backing is from the person on the street. If depositors were to be charged a fee or earn a negative return on their savings this could have an adverse effect on this form of bank funding, with flow-on effects to traditional bank profitability. Indeed, a banks’ own profitability may be squeezed by a fall in net interest margins – the difference between borrowing and lending costs.
Will central banks move?
In response to speculation, both the US Federal Reserve Bank (FED) and the Reserve Bank of Australia (RBA) have recently indicated that whilst a move to negative interest rates is an option, they are not considering such a move imminently or for some time to come. However, in contrast, RBNZ officials have stated that “The committee noted that a negative official cash rate will become an option in the future, although at present financial institutions are not yet operationally ready.” They went on to say, “It was noted that discussions with financial institutions about preparing for a negative OCR are ongoing.”
The obvious question is “for what are they preparing?” There will, of course, be implications in wholesale markets for the settlement and pricing of financial products but what are the implications for retail investors and borrowers? The broader population will see diminished returns affecting both self-funded retirees and retail investors which has the potential to materially impact consumer spending and result in a greater reliance on government support and services. The effects of negative rates are broad-reaching and do not only impact savings rates. In August 2019, a bank in Denmark offered floating rate mortgage holders a loan with an interest rate of -0.5% which resulted in a reducing principal amount owed to the bank. Hardly a signal of an economy in good health.
Officials from the Bank of England (BoE) have recently voiced a change of opinion, more aligned to that of the RBNZ with Governor Bailey stating that the BoE is ”looking very carefully at the experiences of those central banks that have used negative rates, and a number of them are actually publishing quite interesting assessments at the moment.” Since lowering the OCR to 0.1% in March, financial markets have interpreted the BoE’s comments – alongside a deteriorating domestic economic environment due to COVID-19 – as validation of an imminent move to below 0% which has led UK Gilts (bonds) to trade below 0% for maturities out as far as five years.
Is any such move in New Zealand imminent?
Whether the RBNZ will adopt a negative OCR policy is uncertain, but the timing of any such move has almost certainly been pushed out until early 2021 given they recently indicated the OCR would be held at 0.25% until March 2021. After taking bitter medicine, New Zealand has positioned itself well for life and recovery after COVID-19 and this success has seen a relaxation of some self-isolation constraints. However, we are not in the clear, not yet. Confidence in safety has been dented, people’s individual response and adaptation are varied, and workers are being retrenched. Employment is a key component of any economic recovery, prosperity and of course, individual’s self-esteem and any crisis of confidence will no doubt bear down on the economy for some time to come.
Much will need to be considered by the RBNZ before any move to negative interest rates: is it effective, what will the repercussions be, will there be a ripple effect elsewhere, how will individuals perceive the environment of such a move and what circumstances need to be in place for such a significant change in policy?
Without a doubt, we will see signposts along the way that will help us navigate any change in environment and the RBNZ will not wish to surprise individuals, companies or investors by any change in policy. Whilst this is not necessarily our central case scenario, we do need to be prepared that such an option not only exists but that it may well be invoked here in New Zealand.
As always, time will tell, and we shall remain vigilant.
Global Fixed Income Manager
2 June 2020
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