Even before the advent of COVID-19, Reserve Bank governor Philip Lowe told Federal Parliament’s Standing Committee on Economics that the RBA was prepared to do “unconventional things” to kick-start a flailing economy. The RBA cut rates to an unprecedented 0.25% in March this year. At its meeting this week it lowered its cash rate target to 0.1%. That is very close to zero - is it possible for rates to go negative?

The ABC’s David Taylor has pointed out that if you take into account inflation then rates are already negative. The value of money banks are lending is falling by 0.7% pa while their effective rate of return is currently 0.13% p.a.

What happens when rates go below zero?

Under a negative interest rate, the rules start to look a little topsy-turvy. If the RBA adopted a negative cash rate it would effectively be charging the commercial banks to leave their deposits there.

This is seen as encouraging the banks to make more of an effort to lend the money rather than suffer the indignity of paying the RBA to hold their cash overnight.

We’re used to higher rates, meaning returns on cash investments are stronger and borrowers needing to pay back more on their home loans. As rates fall, cash sees weaker returns on savings, and those with mortgages can find themselves with extra money to spend.

Negative interest rates are intended to encourage spending even more than low interest rates. That’s because customers receive benefits for borrowing - those who borrow money would see their lender potentially paying them interest.

A $100,000 loan at a fixed interest rate of minus 1% - as an example - would earn a borrower almost $85 in interest each month. It is this freeing up of capital that makes negative rates an option.

But for the banks, losing money when lending could mean a big dent in profit margins, and a less favourable landscape in which to lend. Likewise, zero-to-slim returns on savings accounts means banks risk having customers remove their money to invest elsewhere.

As David Taylor puts it, the reality is more akin to a highly distorted banking system. Borrowers would repay less than they borrowed at the outset and depositors would earn little or zero on their savings. It is unlikely that banks would charge for deposits because this would simply result in mass withdrawal of funds and stall the banking system. The business model will have effectively collapsed.

Has this occurred anywhere else?

As well as encouraging spending, negative rates are also designed to keep a country’s central currency value low, with the aim of bringing in overseas spending and boosting exports. The European Central Bank - the central bank for the 19 member states of the European Union - has been "charging" commercial banks to hold deposits since mid-2014. And negative interest rates have also been introduced in Sweden, Switzerland and Denmark.  In 2016, Japan became the latest country to introduce negative interest rates. The move was designed to stop a rise in the value of the yen hurting the country’s export-reliant economy.

In August 2019, Jyske Bank in Denmark offered the world’s first negative interest rate mortgage. Jyske Bank is able to go into money markets and borrow from institutional investors at a negative rate, and is simply passing this on to its customers.  Taking one out means that you’re still required to make regular payments to repay the principal, but instead of interest being calculated and added to the value of the loan each month, it’s subtracted!

“We don’t give you money directly in your hand, but every month your debt is reduced by more than the amount you pay,” said Jyske’s housing economist, Mikkel Høegh.

Would it work?

Dr Lowe of the RBA remains reluctant to deploy negative interest rates. He believes the costs of a negative cash rate would exceed the benefits and the other is that he doesn’t believe they work. Countries which have adopted negative interest rate have done so out of necessity, not choice. And the performance of economies since they introduced negative rates would suggest the policy has been less than effective. The eurozone’s annual GDP growth has been about 1.8 per cent since 2015 and Japan’s less than 1 per cent since 2016.

The ability for central banks to influence investment through interest rate manipulation is now clearly limited. Soon governments will have no choice but to provide direct stimulus to the economy to keep things moving in the right sectors. Because so far, simply giving people more disposable income does not necessarily port investment into the right areas of the economy, or even create investment at all.

References

Collinson, P. (2019) Danish bank launches world’s first negative interest rate mortgage. The Guardian.

Uncharted waters: what happens if rates go sub-zero? Your Loan Hub.

Taylor, D. (2020) The Reserve Bank may cut interest rates to very close to zero — so what does that mean for borrowers and savers? ABC News.

Bartholomeusz, S. (2020) No negative interest rates here please, Dr Lowe. The Sydney Morning Herald.

Standing Committee on Economics (09/08/2019). Reserve Bank of Australia Annual Report 2018. Parliament of Australia. (2019)

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