Brian Fallow: Would negative interest rates be a positive move?

The Reserve Bank looks likely to push its official cash rate into negative territory next year. Photo / Getty Images

COMMENT:

You know you are in trouble when your central bank is talking about taking its policy interest rate negative.

The aim would be to lower retail interest rates — normally, a powerful stimulus to administer to an ailing economy.

But at the currently available dosage of that drug, its efficacy is debatable and its side-effects could be seriously negative.

On the efficacy question, credit data released this week show that in the year to July 31, even with interest rates at historic lows, private sector credit growth at 3.8 per cent was the weakest it has been for eight years.

And almost all of it was increased borrowing by households. Lending to businesses was up just 0.1 per cent on a year ago, the weakest rate for nine years, while lending to farmers fell 1.3 per cent, the weakest for at least 30 years.

In the last three months, a period after the country emerged from alert level 4 lockdown, business lending has fallen 4.2 per cent.

That tends to support the intuition, reinforced by evidence from business confidence surveys, that it is not the cost of credit which is holding firms back from investing and hiring. It is uncertainty and weak demand.

"As for householders, theoretically, lower interest rates will increase cashflows for those in debt and encourage those with low levels of debt to borrow more," says BNZ's head of research, Stephen Toplis.

"For now, though, the biggest concern facing householders is the security of employment. And we are less than enthusiastic about householders taking on more debt, and the risks that accompany it, at this juncture."

One group of potential casualties at even lower interest rates are first-home buyers. It might be tempting — with mortgage rates at historic lows, house prices flattening and loan-to-value ratio restrictions suspended — to climb onto the ladder of home ownership.

But if that means getting up to their nostrils in debt to pay house prices that are historically high multiples of (precarious) incomes, caution would be advisable.

More broadly, as ANZ chief economist Sharon Zollner reminds us, low interest rates tend to pump up asset prices.

"The Reserve Bank has made it clear they think a deeper-than-necessary recession is worse for financial stability than the risk associated with carefully designed unconventional policy, and that persistent unemployment is worse for inequality than asset price inflation," she said.

"But the fact remains that extremely low interest rates for prolonged periods are highly distortionary. They can encourage unsustainable borrowing, lead to asset price bubbles that worsen wealth inequality and raise financial stability risks, [and] encourage inappropriate risk-taking."

In a Zoom speech to Victoria University's School of Government on Wednesday, Reserve Bank governor Adrian Orr pushed back against the perception that easing policy would only benefit those with assets.

He acknowledged lower interest rates inflated asset prices. That is one of the ways monetary policy works. Higher house prices, for example, make people feel wealthier, more inclined to spend, which supports the economy. However, job security and a predictable household income had the most immediate and beneficial impact on economic wellbeing, he said.

Unemployment worsened economic wellbeing and underpinned income inequality. And periods of unemployment were both more likely and persistent among people with lower skills or more transitory attachment to the labour force, especially the young, women, and Māori and Pasifika.

Another often overlooked group to worry about is savers.

It is accepted that a negative official cash rate would not pull deposit interest rates into negative territory.

But term deposit rates are already so low that when adjusted for expected inflation and (let's not forget) tax, they deliver negative returns.

Since the crisis hit in March, deposits, especially in savings accounts, have grown strongly.

Reserve Bank governor Adrian Orr. Photo / File

The Reserve Bank forecasts the household saving rate to be modestly positive over the next three years at around 3 per cent of disposable income.

If so, that would be a departure from our normal (but internationally exceptional) pattern. For all but six of the past 25 years, New Zealand households have consumed more than their collective disposable income.

That is a rational response to a tax system which for a generation now has told us that if you want to provide for your age, don't save money — if you do they will tax you every step of the way — but borrow as much as you can and use it to bid up the price of housing.

It would be a shame if monetary policy were now to reinforce the message that saving is a mug's game.

As for whether lowering interest rates further would be attempting to ignite wet wood right now, Orr acknowledged that so far, after the initial wave of the pandemic, household spending and business investment had lagged behind incomes and earnings.

But it was still too early to tell how, if at all, things are different this time. Would people's reactions be more delayed or muted, or would the historically low interest rates and significant disruption facilitate a necessary investment recovery? Most likely it would be a bit of both.

Bank economists, while now accepting that the Reserve Bank is likely to take the official cash rate negative next year, are generally sceptical of the merits of the policy.

They might be accused of talking their book. A negative OCR would have a number of unpleasant effects on banks' balance sheets and profitability, reducing net interest margins and return on assets.

So it is expected that a negative OCR would be accompanied by a "funding for lending" programme, offering them ultra-cheap funding from the central bank. Another possibility is a "tiering" provision which would exempt some of their reserves on deposit at the Reserve Bank, which are ballooning as a result of quantitative easing, from the tax of a negative OCR payable on them. Designing the conditionality around those measures, and planning an exit strategy, must be challenging for the temple priests at the Reserve Bank.

At some point, though, the squeeze on the banks would trigger a credit crunch, rendering the policy counter-productive. Estimating where that level is — in the jargon, the effective lower bound — is not a process about whose outcome anyone should be dogmatic. But minus 0.5 per cent seems to be the current guess — 75 basis points below the current level.

And in any case, even short of the effective lower bound, the pass-through from a lower OCR to lower retail rates is liable to be less than one-for-one.

The US Federal Reserve and the Reserve Bank of Australia are not fans of negative rates.

At the moment only three central banks, those of Switzerland (minus 0.75 per cent), Denmark (minus 0.6 per cent) and Japan (minus 0.1 per cent), have negative policy rates.

Sweden's Riksbank and the European Central Bank have had negative policy rates in recent years. Opinions differ on the results.

One member of the ECB's executive board, Isabel Schnabel, last week defended the policy. It worked as intended, she said, and the negative effects on banks from lower net interest income and the charge on excess reserves were broadly compensated by a reduction in lower loan loss provisions.

But that raises a question: why, in the grip of pandemic and a gruesome recession, haven't Dr Schnabel and her colleagues on the ECB's governing council seen fit to take the ECB's rate negative again?