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What is the point of ultra-low and negative interest rates – and who do they help? - SMH - Stephen Bartholomeusz October 2, 2019 Why do central banks cut short-term rates below zero? Why would anyone sign up to lose money? Who benefits and who loses? With a Reserve Bank cash rate below 1 per cent we are now within sight of something that was once inconceivable, a cash rate at or below zero. On October 1, the RBA cut the cash rate to 0.75 per cent, with its governor, Philip Lowe, saying it was prepared to ease monetary policy further to support economic growth. Minutes of an RBA board meeting earlier this year revealed the bank's board had also discussed the use of unconventional policies such as negative interest rates and the buying of government bonds and other fixed interest securities to lower longer-term interest rates. Zero or below cash rates are hardly unprecedented elsewhere. The European Central Bank’s equivalent to our cash rate is minus 0.5 per cent and in Japan it’s minus 0.1 per cent. In the aftermath of the financial crisis, the US Federal Reserve Board cut its short-term rate to zero. Around the world, there are now almost $US15 trillion ($A22 trillion) of mainly government bonds (debt) with negative interest rates, or yields. In August, that number’s recent peak was about $US17 trillion ($A32 trillion). In Germany, the European economic powerhouse, the government issued 30-year bonds with an interest rate of minus 0.11 per cent earlier this year – investors who lend money to the German government in that issue will, if they hold the bonds to maturity, have signed up to lose money every year for 30 years. It is becoming common in Europe for even companies to issue bonds with negative yields. And in Denmark, Jyske Bank is even offering negative mortgage rates. It is paying home buyers 0.5 per cent to borrow money. The negative rates in Europe and Japan, and historically low rates in the US, have forced global interest rates lower and created global interest rate settings never previously experienced. Why do central banks cut short-term rates below zero? Why would anyone buy a bond that guarantees they will lose money if they hold it to maturity? Why would a bank pay someone to borrow from it? Why do central banks cut short-term rates below zero? Negative rates are a form of unconventional monetary policy. The aim of these multi-faceted policies that central banks employed after the financial crisis was to lower borrowing costs to the point where they "encouraged" banks to lend and companies and people to take more risk in order to receive positive returns. Banks, which are required to hold significant reserves of cash and other high-quality forms of liquidity to protect against a "run" by depositors and wholesale funding providers (insurers, pension funds, fund managers etc), park most of those reserves with their central banks. Unconventional policies are designed to coerce the banks to behave differently. Policymakers want to prod the banks, to the extent that they have excess reserves, into lending and generating economic activity rather than being penalised and losing money by leaving the funds with the central bank. Cutting short-term rates alone isn’t sufficient to make the coercion work, which is where quantitative easing, or central bank buying of bonds and other fixed interest securities such as mortgages comes in, which further pushes down interest rates. In Germany and other parts of Europe, entire yield curves (graphs that plot how much it costs to borrow money over time) are negative – meaning investors can’t get an appreciably better return by investing in longer-term bonds and other securities and are therefore forced to accept more risk for positive returns. Why would anyone buy a bond that guarantees they will lose money if they hold it to maturity? Investors buying bonds with minimal to negative yields are doing so for a variety of reasons. Banks, insurers and defined benefit pension funds don’t have much choice but to hold some government bonds, regardless of the yields, because their prudential regimes require them to hold a significant proportion of risk-free and low-risk assets. Other investors are prepared to pay an issuer what is, effectively, an insurance premium to keep their funds safe and avoid losing even more elsewhere – a conservative move in a risky situation and a more aggressive version of you or me keeping our money in a bank term deposit paying less than the inflation rate. Other traders betting that rates will fall even further are looking for a capital gain as bond prices rise. There is an inverse relationship between a bond’s price and its yield. As yields fall the prices rise, and vice versa, so an investor might buy a bond with a negative rate believing that future issues of similar bonds would have yields that were even deeper into negative territory, making their own bonds more valuable. Why would a bank pay someone to borrow from it? The belief that they will be able to borrow at even more negative rates explains why a bank might offer a mortgage with a modestly negative interest rate. The gap – or spread – produces a profit that makes the exercise add up for the lender. There are winners from ultra-low or negative rates. As indicated, the search for returns in a low-rate environment forces investors into higher-risk assets, such as shares or property. Those who had the capacity and willingness to invest in those assets in the post-crisis period have experienced tremendous returns. Those without the means, or who were risk-averse, have been punished by the low-rate, low-growth environment since 2008. While it was a side-effect, the policies of the central banks post-crisis have exacerbated financial inequality. The "haves" with their share and property portfolios have become wealthier; the "have nots" with their bank deposits have seen their income diminish and, in real terms, their savings being shrunk. China is one of the nations that has cut its interest rates. Do unconventional monetary policies work? Even though the European Union has just lowered its benchmark rate from minus 0.4 per cent to minus 0.5 per cent and resumed its buying of bonds (about $A32 billion a month) and the US Federal reserve has cut the federal funds rate by 0.5 per cent this year and has canvassed the possibility of re-starting its purchases of bonds and mortgages, there is still debate about the effectiveness of ultra-low-to-negative rates and quantitative easing. There’s no doubt it helped in 2008 and 2009 when the global financial system was being stressed to breaking point, and that it has protected employment levels in the major economies but the inability of the major economies to normalise their monetary policies more than a decade after the crisis suggests the policies haven’t resolved underlying economic weakness. Explainer What is quantitative easing? And what’s helicopter money? The policies might even be counter-productive. Ultra-low and negative rates squeeze the net interest margins of banks (there’s a limit to how far they can cut deposit rates in line with their lending rates if they want to retain deposits), their profitability and their ability and willingness to lend. They undermine the business models of insurers and defined benefit pensions funds by reducing the investment income from their capital and reserves while, because the insurers and funds discount their future claims and benefits liabilities using risk-free (long term sovereign bond) rates, swelling those liabilities. They reduce the capacity and propensity of some consumers to spend while, despite the ample availability of cheap debt, the emergency measures adopted by central banks make businesses nervous about investing. Japan has had low rates and its version of quantitative easing since the 1990s and is still trapped in an economic winter. Unconventional policies are treatments, not cures. That won’t stop the RBA from pushing the cash rate below zero, or even introducing its own version of quantitative easing, if it feels the circumstances make it necessary. Aussie dollar hits 11-year low after RBA cuts rates, hints of more to come That might be because the economy is tanking and unemployment spiking but it might also be because other major central banks are forcing its hand. With the European Central Bank, Bank of Japan, the People’s Bank of China and the Fed all reducing their interest rates, the RBA has no option but to track behind them rather than risk a surge in the value of the Australian dollar as global capital flows were attracted by the higher relative rates. It could be very destructive to an open Australian economy that’s already faltering if the dollar appreciated significantly. |
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