Interest rates; lower for longer. What and why?

People are confused. Why might interest rates go negative and what does it mean for investments?

The why

By lowering interest rates the Reserve Bank of New Zealand, and other central banks around the world, are doing several things simultaneously:

  1. They are encouraging individuals to borrow more money and spend, thereby keeping more people in jobs.
  2. They are encouraging businesses to borrow more money, expand their businesses and keep people in employment.
  3. They are reducing the costs for people with mortgages giving them more money to spend on other things.
  4. They are reducing the costs for businesses with debt, thereby helping them survive, keep them employing people and even expand, if they can.
  5. All other things being equal, they are encouraging international investors to ditch their New Zealand bonds and take their money elsewhere, thereby selling New Zealand dollars depressing our exchange rate. This makes our exports more competitive, stimulating our export sector (more jobs there) and makes imports more expensive stimulating our import substitution industries (more jobs there). Hopefully keeping more workers employed, feeding their families and spending money.

As you can see, there are lots of good reasons to make interest rates go lower at the moment.

There are other things that the Reserve Bank can do under the broad heading of monetary policy and we have talked about some of them in previous articles. One such tool is referred to as ‘printing money’.

In summary, by lowering interest rates the Reserve Bank is trying to stimulate the economy to stop it sinking into a hole as the disruptions from the Covid-19 shutdowns take effect.

The Reserve Bank is trying to look ahead and imagine the worst that can happen to our economy and try and reverse the worst of it.

The how

The Reserve Bank does not control all the interest rates we pay in the economy. Only the rate that they charge the trading banks overnight if the trading banks are short of money at the end of the day’s trading.

Everything flows on from that overnight rate set by the Reserve Bank.

If the Reserve Bank charges the trading banks 0.25% per annum overnight if they are short of money for that day, then that sets the base interest rate level at which trading banks can borrow.

Trading banks can then charge a bit more to their customers and make some profit on the way through.

Note that the Reserve Bank is not the only place trading banks borrow their money from. They also get it from the public via term deposits and bank bonds.

Negative interest rates

There has been a lot of talk about negative interest rates. What does that mean and what could it mean for those of us with money we have lent to our banks?

The talk of negative interest rates is all about the overnight rate the Reserve Bank charges the trading banks for being short. It is not about what the banks will give term deposit holders. That rate is more to do with supply and demand, and what the competition is offering depositors.

Could term deposit holders ever have to pay their trading bank to ‘invest’ their term deposits? Yes, they could, but it is unlikely. Several banks have been in print saying that they might go as low as 0% on some term deposit rates, but no lower. And that is assuming that the Reserve Bank has gone to -0.25%.

Will it come to this? Probably. It is being prepared for. But the Reserve Bank is also doing several other things to stimulate the economy like making cheap money directly available to the trading banks to lend on to all of us.

Governments too are, or should be, doing their bit. Borrowing money and spending it as fast as possible. Not tying it up in bureaucratic processes.

So, get borrowing and investing in productive enterprises other than just building new houses. Doing up the old ones is a good place to start. Our housing stock is not that great on a world scale and all health starts with a warm, dry home.

On the investing side of things, talk to a financial adviser. Get some personal investment advice. Lending to the trading banks is fine, but it will not help you counter inflation. It is a safe haven for immediate use, not for long-term needs. Long-term money needs something a little bit more volatile than bank term deposits.

Keep asking great questions …