MD, Salt Funds Management
Last week marked a milestone in NZ financial history, with three year government bond yields dipping into negative territory. While the cash rate target is still at +0.25%, the RBNZ has convinced investors that they will go negative. Is this a good idea? Beyond further inflating equity and property markets, will it stimulate the real economy?
As eminent economist and ex-US Treasury Secretary Larry Summers put it on his twitter feed, “interest rate cuts, even if feasible, might at best be only weakly effective at stimulating aggregate demand and at worst counterproductive.”
Our first question is why is the RBNZ so keen? The RBA and US Federal Reserve are wary and the evidence regarding the impact of negative rates around the world is not encouraging.
Japan’s experience is sobering. They lifted their inflation goal from 1% to 2% in 2013 – we moved ours to focusing on the 2% mid-point from 2012; they have had negative rates since 2016 – we have just gone there; they engaged in massive QE purchases of government bonds which then morphed into corporate bonds and equities - we have started aggressively buying government bonds. None of this has worked. Europe is in the same boat.
Our second question is based on recent academic research about the existence of a “reversal rate”. Cut rates below this and the central bank can have a perverse negative impact on the economy.
The key reason is the negative impact on the banking sector. Love banks or hate them, they are the key channel for credit to flow through the economy.
As interest rates fall to low levels, the initial impact on banks isn’t too bad. While they get hurt by lower net interest income, this is offset by a positive revaluation of their loan assets – banks always have longer duration lending books than funding books. However, as time goes by and rates fall further, the net interest income impact gets worse but the positive effect on assets gets smaller as they mature. As any European or Japanese bank will attest, lower bank profitability means less loans.
This combination of effects means the reversal interest rate rises over time as banks’ assets shrink. The more the central bank bashes its head against the wall and cuts further, the greater the negative net impact on the banking sector and the less its ability to lend.
The RBNZ appears to recognize an impact on NZ banks with their interventionist move to stop them paying dividends. Studies show the reversal rate is even higher when banks’ equity position is weak. Further the RBNZ has talked about a funding-for-lending scheme, where the state substitutes for the market. However, the size and conditions of this are yet to be seen and it doesn’t really address the reversal rate issue.
The third question is that there is significant evidence of cash hoarding at very low rates. Just look at the chart below from Germany. After declining as yields fell, savings suddenly reversed and started rising as the bund yield fell through 0%-1% and spiked when it went negative. It may be that some consumers have target savings and income levels, so perversely save more rather than less. It could also be that the negative interest rate signal scares the living daylights out of consumers and firms and lifts their precautionary saving motive.
Our fourth question is how big an impact will lower interest rates have in driving firms to invest? Business survey evidence suggests that the cost of funding isn’t the key problem for companies at present – it is uncertainty about future demand. Even if it seems to make sense to invest right now, it is logical for a firm to wait given the highly uncertain state of the world. There is significant option value in waiting in case your investment turns out to be a dud. This isn’t the RBNZ’s fault but it does mean they may be disappointed in how weakly investment is stimulated.
Our fifth question is the impact of low/negative rates on financial and property markets. Listed equities, residential property and some forms of commercial property are now on amongst the most expensive valuation ratios in the world. It is semantics as to whether they are extremely frothy or in a bubble. What happens if something changes and valuations fall sharply back to more normal levels? A bursting bubble would suppress economic growth for many years thereafter. Far more heed should be paid to “irrational exuberance” and the problems that follow a bursting bubble given the RBNZ’s role in ensuring financial stability.
NZ’s government debt levels are rising but still fine. However, consumer debt levels are extremely high on a global basis at around 90% of GDP. The risks of financial instability in any future bust are significant and these risks are being exacerbated by ultra-low/negative rates. NZ is doubling down on consumer indebtedness.
Our sixth question is the NZ$ channel. This is where negative rates can actually work if the RBNZ weakens the NZ$ by going harder than other central banks. As a small open economy, we are in a better place than Japan or Europe. However, this comes with a longer term risk of a sharper than desired depreciation. This is quite possible when the monetary base is expanding dramatically.
Our seventh question concerns the zombification of firms. Dynamic economies reallocate capital from businesses that are dying and allocate it to those on the rise. Studies suggest that ultra-low and negative rates sink economies into a state of torpor where this natural process of life and death is put into a form of deep freeze. Dying businesses can survive in a state of purgatory suppressing the profit pool throughout their industry.
Our eighth and final question is a distributional one. By sparking booming financial and property markets, the benefit of negative rates accrues to the top 10% and especially the top 1% of the population who own all the capital. Ordinary income earners are left behind. For now, a capital gains tax is the untouchable third rail of NZ politics, but at some point, negative rates will become socially and politically unsustainable. Interestingly, the truly radical approach of “helicopter money” being credited to consumers’ bank accounts would not face this problem.
To conclude, we hold little hope that the RBNZ’s determination to move to negative interest rates will achieve much for the real economy other than holding down the NZ$ to some degree. Conversely, sinking bank profitability, spiking precautionary saving and driving financial market euphoria does not appear an obvious recipe for success. The evidence from Europe and Japan is discouraging. Rather than risk making a bad situation worse, perhaps the RBNZ should accept that monetary policy has reached its limits in conventional terms. Truly crossing the Rubicon and taking extraordinary risks with direct debt monetization or helicopter money might be another matter.
If the answers don’t lie with the RBNZ, where do they lie? There are few obvious magic bullets but good starting points might include using ultra-low rates to fund infrastructure with very long term debt, aggressively attracting skilled entrepreneurial immigrants once borders re-open and engaging in hard-nosed supply-side reforms to enhance productivity.