Week in Review

What happens if interest rates hit zero?

The Reserve Bank cut the cash rate to a record low and is considering how to stimulate the economy if it ever had to cut it to zero percent. Bernard Hickey looks at the options, which include negative interest rates and creating money to buy assets.

How low can you go? And what can or should you do if you cut it to zero percent?

These were the questions no Reserve Bank Governor ever thought they'd have to answer, but they were part of the discussion this week for Adrian Orr after he announced the bank had cut the Official Cash Rate by 25 basis points to a record low 1.5 percent.

They are also questions the Government will have to think about, given the money printing tried overseas when rates hit zero percent succeeded only in making rich asset owners even richer, while the fresh money failed to filter down

The cut itself wasn't too much of a surprise. It was expected by a majority of economists and financial markets had priced in a 50 percent chance of a cut by the bank's new Monetary Policy Committee. Orr warned the markets at the end of March that the next move was likely to be a cut.

But it's worth zooming out a little to look at the context for the cut, which is the seventh over the past five years and the first since Orr was appointed in March last year. It was also the first cut under the Reserve Bank's new monetary policy decision-making regime with a committee instead of a single decision maker.

Borrowers and savers with a few grey hairs will be shaking their heads. It's not supposed to be like this. New Zealand is in the 10th year of an economic expansion with unemployment of 4.2 percent, which is near a record low and supposedly indicative of an economy at full capacity and starting to generate inflationary pressures.

Same jobless rate. Much lower interest rates.

Normally (if there is such a thing now) a central bank would be well into a series of rate hikes about now. That was the case in mid 2007 after eight years of economic growth, which was also the last time the unemployment rate was heading under four percent.

Back then the Reserve Bank under Alan Bollard was forced to hike the OCR to 8.25 percent as inflation threatened to spike well above three percent. Fixed mortgage rates got up to almost 10 percent and the floating mortgage rate to almost 11 percent.

Fast forward 12 years and banks are offering fixed mortgage rates of 3.99 percent at the same time as the unemployment rate stands at 4.2 percent.

Orr said he expected a competitive banking market would see the 25 basis point cut passed on in full, despite talk from the banks that Orr's plans to double their capital requirements would force them to build up their profit margins. Not passing on all the rate cut to floating rate borrowers at the same time as passing all the cut on to savers would boost profit margins.

So far this week the big Australian banks have passed just 10-15 basis points of the cuts to fixed rate borrowers and even less to floating rate borrowers. However, to be fair, they have also held back from inflicting all the 25 basis points in cuts to savers.

Diminishing returns?

The limited initial pass-on does beg the question: is there any point in cutting the Official Cash Rate if the potency of monetary policy is diluted as the rate gets ever closer to zero percent.

Orr said the bank did not believe there were diminishing returns for monetary policy as interest rates got ever lower. This is often referred to as the zero 'lower bound'.

However, he acknowledged the bank had begun thinking about what to do if (or when) the OCR got down to zero percent, as happened in America, Britain, Europe and Japan over the past decade in the wake of the Global Financial Crisis.

Some central banks (Europe and Japan) dragged official rates into negative territory, meaning banks had to pay the Reserve Bank to look after their deposits. Few banks passed on the negative interest rates to their customers, fearing many would withdraw their money to keep it in cash or invest it in other assets that didn't require the saver to pay the bank.

All of these central banks launched asset purchase programmes that were euphemistically called Quantitative Easing.. Essentially, the central banks invented money to buy Government bonds, mortgage bonds and in some cases  (Japan) even shares.

Central banks in America and Britain have stopped their asset buying, but Japan and Europe are still going. With Switzerland, the world's biggest central banks have pumped over US$10 trillion into global bond markets. This pushed down long term interest rates and pushed up the values of other assets such as shares and property.

The criticism was this money printing simply increased the wealth of the already wealthy and did little to pump real money into the hands of spenders, who would be more likely to push up demand for goods and services, and therefore to lift inflation.

QE for the people?

Some have called over the past decade for much more direct stimulus where the central banks printed money and handed it out equally to citizens to spend on whatever they wanted, or to repay debt. This has been termed 'QE for the people.'

I asked Orr about what he preferred the Reserve Bank do. He was guarded about the prospects for asset purchases or what types of assets the bank could buy. He would not comment directly on the idea of a 'QE for the people.'

However, if the bank gets to that point, it will be in uncharted territory where monetary policy is doing more than just stimulating the economy. It would also in effect be making policy that redistributed wealth and income, which is usually the job for a Government.

Surely we won't get to zero?

Most would still see the prospect of a zero percent OCR as extremely unlikely.

But most also saw 1.5 percent as too low as recently as even last year.

Inflation has been stubbornly low in the wake of the Global Financial Crisis and the rollout of billions of smart phones.

Apps such as Uber, Airbnb, WhatsApp, Spotify, Netflix and Facebook have slashed prices of all sorts of goods and services, effectively turning smart phones into globalised deflationary machines.

Labour markets have also globalised and the power of workers to push up wages has shriveled to an extent that wage inflation is negligible in most developed economies, despite extremely low unemployment and solid jobs growth.

Right now zero percent interest rates are unlikely, but increasingly the Reserve Bank is eyeing the prospect just in case.

It published a bulletin article in May last year looking at implementing 'unconventional' monetary policy here, concluding it would not be so easy for New Zealand to buy huge amounts of Government bonds because there is such a small amount of Government bonds on issue relative to other countries.

A more obvious solution would be for the Government to issue bonds directly to the Reserve Bank in exchange for freshly printed money. That's exactly what the first Labour Government did after the Great Depression. It borrowed money directly from the newly created Reserve Bank.

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