What would happen if interest rates fell to zero or negative?

What would happen if interest rates were zero or negative?
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With New Zealand's Official Cash rate now at 1 percent, current global uncertainty begs the question of what would happen if it were to drop further... even fall below zero.

Several countries currently have zero or negative policy rates. If the OCR were to drop again here, low interest rates may provide additional stimulous but the prospect of the rate falling too low raises important questions for Kiwi savers and foreign investment.

Are further cuts to the OCR expected?

Recent reports of weakened global activity and interest rates at historically low levels, slowing GDP growth as demand for New Zealand goods and services eases and trade tensions between the US and China all point to a glum economic picture. 

The ANZ Business Outlook survey indicates that business confidence fell 6 points In July: a net 44 percent of respondents report that they expect general business conditions to deteriorate in the year ahead. On a positive note, unemployment remains low (3.9 percent in the June 2019 quarter) and the survey reports that only a net 6 percent of companies expect to cut jobs over the next year.

Released prior to the OCR cut in August, the survey cited that two more OCR cuts were expected this year, a sentiment echoed in Tony Alexander's weekly overview of 8 August which states that a further cut to 0.75 percent can't be ruled out for November.

In his recent commentary on The AM Show, Cameron Bagrie said that given the economic portrait, he suspected that the Reserve Bank would cut the OCR "not just once, maybe two or three times more."

Which countries have negative or below rates?

According to ASB chief economist Nick Tuffley, a few countries currently have zero or negative policy rates: most of Continental Europe, Sweden, Denmark, Switzerland and Japan.

Switzerland is at -0.75 percent and in the cases of Europe and Japan, Government bond yields are currently trading at negative rates.  

"In answer to the question, 'Can interest rates go negative?' Yes they can," Tuffley said.

The question for New Zealand is, will that happen? Tuffley thinks that is less likely.

"One contrast New Zealand has is that they [other countries] are net savers - we are net borrowers," Tuffley explained.  

As borrowers, New Zealand relies on foreigners to lend us money. In Europe, there are people with excess savings who are prepared to hold onto those savings, as there's nowhere to put their money. 

"If world interest rates are negative, New Zealand could also go negative, but the real constraint is 'will foreigners be willing to lend to New Zealand at negative or zero rates?'," Tuffley said.

While that is unclear, what is a strong possibility is that lending rates could drop further in New Zealand, leading to a situation where borrowing could become incredibly cheap.

What would a zero or negative OCR mean for borrowers?

While the OCR doesn't automatically set interest rates on mortgages and term deposits (a margin is applied on top), a low interest rate environment creates relief on mortgage cash-flows, whilst giving businesses the opportunity to reduce their debt servicing and invest in plant and growth.

In an environment of low interest rates, savers bear the brunt while borrowers benefit.  

Yuong Ha, chief economist and head of economics for the Reserve Bank said that negative interest rates [would] accentuate the incentive to borrow and spend today, confirming that in a negative interest rate situation, borrowing $100 today could mean that only $90 is repaid in a year's time. 

"In effect, we will pay you to borrow," he explained.

The Reserve Bank is charged with maintaining strong growth, full employment and inflation close to the target of 2 percent. Cutting the OCR to 1 percent has made it more favourable to borrow and spend today.  

Although it is in the realms of possibility that the OCR will fall to zero percent, Ha is quick to add that New Zealand is [currently] in a relatively good space.

"We're trying to keep it there," he said.

"People will need to recalibrate the new normal of 3 or 4 percent. Five percent is high and 1 percent is low. Where it used to be 6 or 7 percent before, it's 1 to 2 percent now."

Ha explained that they're not telling people to go out and overborrow and the onus remains on lenders to apply normal lending criteria.

His main message for borrowers is that "interest rates will be low for a long period of time. 

"We're not going back to a high interest rate environment any time soon," he said.

What would a zero or negative OCR mean for savers?

While borrowers would be the winners in a zero or negative interest rate environment, savers would not be so flush. People who rely on interest rates alone would bear the brunt.

"In a low interest rate environment, you will think harder about the form of savings you might have," Ha said.

A zero percent environment would likely cause people to ask themselves whether their money is working hard enough - and look at other investments - which of course, may carry a higher risk for a higher return.  

While in countries where policy rates are negative, sitting on savings is one option, another is to diversify investments to limit exposure, taking personal risk tolerance and investment time-frame into account. 

For savers (including retirees), perhaps the most comforting message is in Ha's closing comment.

"We [New Zealand] are still a long way from negative interest rates," he said.