When interest rates fall below zero, things could get weird

Saturday, 20 July 2019

Financial Markets Authority chief executive Rob Everett and Reserve Bank governor Adrian Orr deliver the findings of their joint review into the conduct and culture of banks in New Zealand. First published in 2018.

When former Greens co-leader Dr Russel Norman argued in 2012 that the Government should 'print money' in a bid to weaken the Kiwi dollar, which at the time was buying more than US80c, his opponents seized the opportunity.

Although central banks in other parts of the world were doing so, New Zealand's still relatively high interest rates, and the intuitive problems with the scheme, were used to attack Norman's economic credentials.

Prime Minister John Key described the idea as 'wacky'. Steven Joyce said international markets would look at New Zealand and say 'you're losing the plot'.

Finance Minister Bill English said such a policy suggested there was 'some sort of free lunch', suggesting Norman was undermining his efforts to establish himself as Opposition finance spokesman.

If interest rates drop below zero, it could make better financial sense to lock your savings in box when to have it in a bank account, if the cost of storage cost less than the cost of having money in the bank.

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By mid-2013, the Green Party quietly dropped the call. Norman still thought the idea was sensible 'but the reality is the reality'.

Six years later, the reality is different.

The idea that the Reserve Bank may look to 'unconventional' tactics to keep the economy functioning is now less than farfetched.

Although none of the mainstream institutions are yet saying they predict such tactics are likely, some are openly speculating about what to do when interest rates get close to zero.

'Odds are rising that some kind of significant economic hit will occur before the OCR is back to anything approaching historical norms,' ANZ strategist Sandeep Parekh wrote in a note from June, laying out the 'unconventional' options the Reserve Bank could use next.

These included cutting the benchmark official cash rate (OCR) to below zero, as well as buying government loans, council debt and even packages of mortgages, a tactic commonly known as printing money.

Why is this on the cards?

Interest rates are at all time lows and are headed lower.

Reserve Bank Governor Adrian Orr, pictured at a business event in Invercargill in June has been telling businesses that it is a good time to invest since arriving in the job in early 2018. But confidence is low as companies grizzle about cost pressures. In recent months a rising number have been warning of softening demand.

The OCR is at 1.5 per cent and is widely expected to be cut again in August, with inflation below target in New Zealand and the economy, here and elsewhere, is slowing. In Australia, where the economy is also cooling, the benchmark cash rate could fall below 1 per cent by the end of 2019.

ANZ, New Zealand's largest bank expects the Reserve Bank of New Zealand to cut the OCR to 1 per cent this year.

Kiwibank chief economist Jarrod Kerr said the bank is 'very, very close' to adding more interest rate cuts to its central prediction, meaning the OCR would drop to 0.75 per cent next year.

The problem, in large part, is confidence.

When business confidence plunged after the 2017 election, many people saw it as temporary, partly politically biased and probably fleeting.

But close to two years on, the respected quarterly survey of business opinion (QSBO) hit the lowest level in a decade.

Westpac chief economist Dominick Stephens said that while New Zealand's business confidence had been weak and consumer confidence had been slowing for some time, export prices had remained 'hunky dory'. However in recent weeks log prices have dropped sharply and the bank had trimmed its forecasts for this season's Fonterra farmgate milk price.

The proportion of businesses expecting to see demand fall in their own operations is also at a decade-long high.

Kerr said businesses were worried about rising costs, which meant investment decisions and expansion plans were being shelved.

'That's enough to kill growth overnight.'

Although consumer spending has not plunged, there are warnings the gloom will spread, as job creation slows.

On Friday, Infometrics chief forecaster Gareth Kiernan warned that consumer confidence could be the next 'domino to fall' with a weaker job market and a slowing housing market.

'Households' income and wealth are now both under pressure,' Kiernan said.

Less than zero

Kiernan's latest warning went on to say that the Reserve Bank may have little power to influence borrowing costs, with the last interest cut having little impact on borrowing rates.

But the Reserve Bank is expected to continue to cut for some time yet.

In a paper outlining what it might do if it needed to turn to unconventional methods, Reserve Bank officials wrote in 2018 that, in theory at least, the OCR could be cut to -0.75 per cent.

Although everyday consumer products are not linked to the OCR directly, negative interest rates on other products are not unusual.

Trillions of dollars of government bonds are currently trading with negative yields.

This means buyers are effectively paying governments to hold onto their money.

In some countries, notably Switzerland, bank deposits have reached the point where depositors charge a fee, a measure taken to prevent overseas depositors seeking safety from pushing the Swiss franc higher.

'We had thought, with conventional wisdom, that going into negative interest rates that people would simply hoard cash, but clearly there's a cost to hoarding cash, namely security,' Kiwibank's Kerr said.

'For people in Switzerland and other parts of the world, faced with negative interest rates, [bank accounts] are like a safety deposit box.'

Under the mattress, or locked up

As much as bank accounts may be like safety deposit boxes, eventually the cost of negative interest rates mean actual safety deposit boxes become the best investment.

Physical cash can become the better investment.

The Reserve Bank has noted that there were signs that negative interest rates did lead to an increase in demand for actual cash.

Depositors 'will be prepared to accept negative rates up to the point that the additional costs of holding physical currency - storage costs, insurance costs and transport costs - become lower than the cost of negative rates,' a Reserve Bank article noted.

Alternatively, those who rely on the income of savings will go further to try to find a return, possibly not realising how risky other investments are.

Printing press

Although the Reserve Bank is responsible for the supply of physical currency, when people discuss central banks 'printing money' physical currency is not involved.

Instead, new money is created and typically used to buy bonds (a type of loan), typically from the government.

In New Zealand this is likely to be challenging given that the government has relatively low debt, the majority of bonds are held by overseas investors and a lot of what is left is not for sale.

ANZ's Parekh said this was 'both a blessing and a curse'.

A lack of bonds for sale could mean relatively small purchases may be enough to send a signal to the market 'enough to flatten out the yield curve'.

The yield curve is the difference in interest rates on short term loans and deposits, and long term ones.

In normal circumstances, interest rates are higher on loans or deposits fixed for a long period, but the idea of printing money is to give borrowers confidence that interest rates will be low for a long time (with corresponding pain for those who rely on the returns from deposits).

Combined with assurances from the Reserve Bank that interest rates are to stay at ultra-low levels for a long time could provide confidence for lenders to offer low interest rates on lengthy terms.

Kerr said if the Reserve Bank may look to buy debt issued by councils through the local government bond bank or Auckland Council.

'Maybe you'd go out and buy bank debt, to really push interest rates for the economy.'

If the dollar was seen as hurting exporters, the Reserve Bank would intervene in the currency markets by buying foreign reserves, a tactic it has used outside times of crisis.

Prime the pump

Kerr is also vocal that the Government should be doing more to stimulate the economy by investing in infrastructure. Although it is a call he has made for some time, it is especially the case when the economy is slowing and inflation is lagging.

The Reserve Bank could buy bonds directly from the Treasury to push down the Crown's borrowing rate and publicly urge the Government to do more to keep demand up.

'They [the Government] should be doing more, today,' Kerr said.

'Why do we really need to wait for [economic distress] when there's a desperate need to address what I think is a shameful infrastructure deficit?'

As a last resort, the Reserve Bank could engage in so-called helicopter money, a theory where in dire straits, central banks disburse money from a helicopter in a bid to keep consumers spending.

More likely (but still, very unlikely), money would be given directly to consumers.

None of the interventions come without risk, ranging from seeing the Reserve Bank take on risk which should sit with the private sector and hurting bank profitability.

If the strength of the currency is the problem, intervening in the currency markets could see the Reserve Bank take on investors and other central banks with deeper reserves to draw from.

Stephen Toplis, head of research at BNZ, said not only was New Zealand some way away from unconventional measures, the merits were uncertain. Discussions with Reserve Bank officials were that unconventional monetary policy is 'very much a last resort', Toplis said.

Central banks which had printed money often had negligible impact on inflation and some of the stimulus often did less to stimulate the economy than hoped.

Toplis has been saying for some time that while businesses he spoke had complaints, the cost of credit was not one of them. In the mortgage market, lower borrowing costs would be likely to encourage speculators, rather than helping anyone locked out of the property market.

'I cannot remember the last time I heard someone at one of my presentations complain about interest rates [as a barrier to their business]. It just doesn't come up.'

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