Negative interest rates could be coming in. What would it mean for borrowers and savers?

The Reserve Bank considered it, the big banks hated it, so could negative interest rates really work? Finance professor Harry Scheule from the Sydney University of Technology explains.

A dispute is brewing in the corridors of financial power. The Reserve Bank of New Zealand (RBNZ) recently warned commercial banks that the official cash rate could go from slightly positive to negative.

Right now, the Reserve Bank of New Zealand is delaying such a move in favor of other monetary stimulus measures. But big banks firmly oppose negative rates, arguing that they have had limited success abroad and that the country’s banking technology is not up to scratch.

For the central bank, however, it remains an option to stimulate spending, investment, and employment as part of the Covid-19 recovery. By reducing the cost of loans, economic activity recovers, or so the theory goes.

Among those resorting to unconventional monetary policy are Japan, Switzerland and the European Union. Negative rates range from –0.1% to –0.8% for selected levels of central bank deposits.

In the past, changes in cash rates have resulted in changes in loan and deposit rates. For example, a 25 basis point drop in the cash rate can result in an annual interest savings of $ 2,500 on a $ 1 million loan.

However, at today’s low interest rates, these changes are no longer carried over, significantly limiting the powers of the RBNZ.

Yes the bank pays you to borrow

It may sound crazy, but if the interest rate is negative and you borrow an amount in terms of interest only, the bank actually pays you interest every period. For example, Jyske Bank in Denmark is offering negative interest payments by effectively reducing the repayment period.

Banks should be comfortable offering negative rates to borrowers if, in turn, the banks themselves have savings and other funds at even lower rates.

But here’s the problem: why would savers pay banks to accept deposits? First, they can keep their investments in cash at zero interest rate instead of paying a bank. Second, they can choose to invest in riskier assets with positive interest rates.

Because of this, only very large depositors (with limited capacity to store cash) tend to leave their money with banks that offer negative rates, while ordinary depositors receive a rate of zero or more.

But do negative rates work?

Arguably, the era of monetary policy as a tool to stimulate investment and economic activity has come to an end. Negative rates do not necessarily translate into productive investment and growth.

Countries that have turned negative have not achieved the expected increases in spending and investment. Also, the difficulty of passing negative rates on to depositors means that loan and deposit rates no longer follow the cash rate.

This is also evident in Australia, where a fall in the cash rate from 0.25% to 0.15% has not carried over to mortgage borrowers, except in isolated areas such as fixed-rate loans.

The graph below compares the average variable rate on mortgages to the New Zealand cash rate, and the gap increases over time. Charts for Australia and other developed economies would be comparable.

The Reserve Bank of Australia (RBA) has advised borrowers to switch lenders if they do not pass through the rate cuts. But there is little that central banks can do to offset this systemic problem.

What are the risks?

Negative interest rates are unlikely to be the correct response to the current Covid-19 shocks. Instead of generating more spending, we tend to see the opposite: more savings.

However, in the long term, depositors will seek higher returns and move their funds into riskier asset classes, including real estate markets, which will drive up prices and reduce affordability for new buyers.

Most economists agree that inflation is not a concern for now. But what about the medium term? If interest rates rise again, highly leveraged mortgages can be difficult to service.

Either way, negative rates are not a long-term solution to today’s economic challenges. We need to find ways to make the national economy more flexible, requiring fewer rescue interventions.

The fragility of supply chains and the still limited movement of labor, goods and services must be priorities. New technologies may become key: Innovations that allow you to work from home and organize activities online have already saved entire industries.

Furthermore, the banking system itself needs reform. Banks work under the assumption of shocks that occur once every thousand years, but we’ve seen two in the last 13 years!

After the 2008 global financial crisis, buffers were established in financial systems. For example, bank capital requirements were set high to reduce them in economic recessions. Would now be the right time to finish them off instead of insisting that they stay?

Beyond hitting negative rates, the need to rethink economic fundamentals and create systems that are more resilient to global shocks should be the lasting lessons of Covid-19.

This article is republished from The Conversation under a Creative Commons license. Read the original article.