Last week there was some speculation surrounding Governor Lowe moving the official RBA Cash rate into negative territory. And before we all get overly excited… no this does not mean the banks pay us to borrow money. Nor does it mean that term deposit rates go negative either.
It’s not quite that simple. This article looks at the case for negative interest rates and the evidence of its effectiveness overseas. We see why the Reserve Banks of Australia and the US are reluctant to follow the footsteps of Europe and Japan.
Why are negative nominal interest rates so troubling?
PIMCO Portfolio managers Nicola Mai and Peder Beck-Friis explain that economic theory favours real rates (adjusted for inflation), which have already been negative in most developed countries for some time, including Australia.
In theory, lowering the nominal (before inflation) cash rate into negative territory should produce many of the same expansionary effects as cutting the policy cash rate in a positive rate environment- to make individuals and companies save less, spend and invest more.
They also address that lower real rates should also lead to a depreciating currency, which improves a country’s external competitiveness, and supports asset prices, boosting the wealth of the private sector.
In practice, though, both managers outline that negative interest rates come with three key drawbacks-
They impair the banking system. As the cash rate turns more negative, banks start earning less return on their assets, while the interest they pay on deposits generally stays above zero – due to relatively high competition for deposits, legal challenges, political resistance and the potential for cash withdrawals. As profits decline, banks may issue fewer loans to businesses and households, or raise the interest rates they charge for those loans.
Fewer loans and ability to charge a margin over the cash rate impacts balance sheets, which in turn, has the potential to impact the equity share price as the banks become less attractive.
They create significant challenges for other parts of the financial system. This includes the pension and insurance sectors, which offer nominal return and minimum income guarantees in the future, but that are hard to deliver when interest rates are negative, as they don’t generate enough yield.
Negative nominal rates may lead to more, not less, savings. Economists refer to this concept as “money illusion,” as what should matter – at least if people were completely rational – are not nominal but rather real, or inflation-adjusted, variables. While “money illusion” may hold for rate cuts in a positive rate environment too, the effects are likely magnified under the zero line.
What’s the evidence so far?
The two biggest experiments with negative policy rates have been in the Eurozone and Japan.
Data from the International Monetary Fund (IMF) suggest that when reviewing the GDP of both the Eurozone, which first brought the policy rate into negative territory in June 2014 and Japan (January 2016) the impact of negative rates has been mediocre in revitalising economies. Initially Eurozone GDP managed to creep to or over 2%pa, however, has since fallen. In the same year Japan also saw a surge only to return to its below 1%pa levels.
Overall, the effectiveness of negative cash rate policies suggests the approach is less than effective.
Breaking it down further, Mai and Beck-Friis found that:
The policy has been successful in easing financial market conditions so far.
Negative policy rates have led to a fall in both short-term and long-term market rates, with 2-year and 10-year government bond yields on average declining roughly as much as policy rates. The policy also had a positive impact on risk assets, with stock prices on average rising. Importantly, bank equity prices have suffered in the negative rate environment, challenging the sustainability of any improvements in financial conditions.
However, the policy looks to have had mixed impact on countries’ currencies.
The impact on bank lending conditions appears to have been positive. On average, financial institutions have increased the pace of loan creation, especially in the Eurozone, albeit from a low starting level. However, banks lowered household and corporate deposit rates, by less than the policy rate, while lowering lending rates roughly as much as the policy rate.
The macro impact seems to have been positive, but modest. The policy appears to have been unsuccessful in lifting inflation and inflation expectations
PIMCO studied the effect of negative rates in five different countries all who have implemented negative rate policies. While the policy has been associated with mediocre growth (figure 5), the dispersion of outcomes has been high.
On balance, this lead PIMCO to conclude that negative rate policy does not have much further room to run, and that its persistence will end up damaging markets and the macro outlook.
Governor Lowe’s reluctance to deploy negative rates has been based on two fairly compelling arguments- one is that he believes the costs of a negative cash rate would exceed the benefits and the other is that he doesn’t believe they work. And there is plenty of experience of negative rates elsewhere in the world and little evidence of their effectiveness.
And thus we, the UK and the US are likely to see the respective Central Banks tackle the current environment with quantitative easing measures rather than reducing policy rates below zero.
So, it seems that unfortunately, no, the RBA won’t be paying us to borrow money. But wouldn’t that be a nice cherry on top?.
For the full PIMCO article – Negative rates: negative view click here.
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