What would happen if Australia had negative interest rates? Is that even possible, I hear many of you ask?
Wouldn’t that mean we’d be paying the bank to look after our deposits? What sort of fool would do that?
But that’s exactly what has been happening in Europe where the European Central Bank has been “charging” commercial banks to hold their deposits since mid-2014. Negative interest rates have also been introduced in Japan, Sweden, Switzerland and Denmark.
Why would they do that?
In a weak economy, negative interest rates can be seen as a way to discourage people from hoarding their money.
If they have to pay for the privilege of holding cash in a bank, the theory goes, they’d be better off spending or investing instead.
Or, in the case of banks, they’d be better off lending the money to consumers and businesses rather than keeping it in the central bank. So in that sense, negative interest rates can be a way to kickstart economic activity.
They are also seen as a way to fire inflation in economies where deflation – or falling prices – has become a problem.
The other effect of negative interest rates – and for some central banks this is just as important, or even more so – is that they can take pressure off a country’s currency, making it more competitive on international markets. After all, who would want to invest in a currency that actually costs them money?
Does it work?
It’s unexplored territory and the jury is out. Banks have been reluctant to pass on negative rates to customers, limiting the impact. In an April paper, the International Monetary Fund (IMF) gave qualified support to the policy, saying they should support demand and price stability. But it warned there were limits to how far and for how long negative rates could go.
Critics have pointed out that negative rates can push investors from safe assets, such as bonds and cash, into riskier assets as they chase returns, potentially creating asset bubbles. They also argue that credit availability for lending is not the problem in most economies.
People are already in debt, and they are uncertain about the future, so they are reluctant to borrow more, limiting the effectiveness of negative rates.
Because banks are effectively being taxed to hold money with the central bank, and are not passing negative rates onto depositors, bank margins are also being squeezed, potentially making them unwilling to lend.
The one thing that can be said for certain is that negative rates are not good. They are a sign of economic uncertainty, and that alone is likely to limit their effectiveness.
What would negative rates mean for people like me?
Let’s start with the good news. Interest rates in Australia are still positive in both real and nominal terms. But, as with much of the rest of the world, rates are at historically low levels. The April Reserve Bank cash rate of 2% was just 0.3% above the inflation rate of 1.7%, giving savers a paltry return on their money after inflation.
A 35-year old wanting a $48,000 income in retirement at 65 would need to invest $178,000 today at a 5% interest rate but more than three times that amount – $563,000 – at 2%.
Negative rates could actually have the opposite effect to what was intended by forcing people to cut spending to save more for retirement, and forcing retirees to spend less as they have a reduced income.
As the overseas experience has shown, banks are reluctant to pass on negative rates to consumers for fear of creating a customer rush into holding cash. There have been reports already that safe sales are increasing in countries, including in Germany.
But nor has there been a widespread move to rewarding borrowers. In fact, some borrowers’ costs have gone up through higher fees and other charges as lenders attempt to recoup some losses.
With Australia’s economy still heavily dependent on what happens in China, its economic growth – or lack thereof – will play an important role in our future.