The Reserve Bank is preparing to lend fresh money to banks at negative interest rates from early next year, which would allow them to cut mortgage rates as low as 1.5 percent, Bernard Hickey reports
The Reserve Bank has confirmed it is preparing to lend freshly minted money to banks from early in 2021 at negative interest rates to encourage them to lend more to stimulate the economy and boost inflation back up to around 2.0 percent.
The banks would be expected to lend more to home buyers and businesses at rates as low as 1.5 percent, down from over 2.5 percent currently. That could in turn boost house prices by another 20 to 30 percent if other factors such as home building rates, migration and unemployment were unchanged, Reserve Bank research shows. That $200-300 billion rise in home equity values could, in turn, boost home owner and small business confidence, and bolster spending and economic activity through the wealth effect.
But it would also mean the Reserve Bank was effectively printing money and then handing it to banks for terms of two or three years in exchange for securitised mortgages as collateral. But rather than being compensated for the risk with a positive interest rate, the Reserve Bank would offer a negative interest rate to the banks (ie paying the banks money to borrow off the central bank).
That in turn would allow banks to lower retail mortgage rates beyond their current floor of about 2.6 percent to as low as 1.5 percent, if the Reserve Bank is successful in designing its ‘Funding for Lending Programme,’ which was outlined in the Monetary Policy Statement (MPS) on August 12.
Still under construction
This programme did not get much attention at the time as markets and the public instead focused on the Reserve Bank’s announcements about more Quantitative Easing or money printing to fund Government borrowing and the potential for a negative Official Cash Rate (OCR).
The Reserve Bank announced an increase in its current money printing programme to buy Government bonds in financial markets from $60 billion over the next year to $100 billion over the next two years, with plans to ‘front-load’ those purchases later this year to lower longer-term Government bond yields and allow banks to, in turn, lower their mortgage and business lending rates.
But the Reserve Bank knows it is coming up against what is known in banking and monetary policy circles as the ‘zero lower bound’ problem. Normally, the Reserve Bank can expect a cut in the Official Cash Rate (OCR) to be enough to push retail interest rates lower as banks pass on lower wholesale interest rate costs in the form of lower retail rates for mortgages and business loan rates.
But that also assumes that banks are able to pass on that lower OCR to term depositors. One thing stopping banks from lowering their mortgage rates much beyond the current 2.6 percent floor is that their $280 billion worth of mortgage lending is partly funded by $185 billion worth of term deposits by households and others. The OCR is now 0.25 percent and the banks would be unable to pass on negative OCR to mums and dads who are saving. No one expects the banks to try to ‘charge’ savers money to put their money in the bank.
So the Reserve Bank is trying to get around this ‘zero lower bound’ problem by looking at lending directly to the banks at negative rates to lower their funding costs. Bank net interest margins are around 200 to 250 basis points above the OCR, which means the banks cannot lower mortgage rates much below the current 2.6 percent when the OCR is at 0.25 percent.
It is one argument some make for saying a negative OCR is pointless because banks can’t normally increase lending, and it effectively cuts into their profits and makes them weaker.
But the Reserve Bank’s Monetary Policy Committee asked the bank in its August 12 decision to look at building a special lending scheme whereby banks could borrow fresh money directly from the Reserve Bank in a way that a negative OCR could be passed on into ever-lower retail rates. The OCR and the lending facility, called a Funding for Lending Programme, would be a package deal.
“A term lending programme would lower bank funding costs, both directly and indirectly, by reducing banks’ demand for, and hence the price of, other sources of funding,” the Reserve Bank wrote in the MPS.
“This would in turn help to lower the cost of loans for households and businesses. A term lending programme may be increasingly useful for supporting the pass-through of monetary stimulus if the OCR were reduced. The programme could help to ensure that bank lending rates remained responsive to declines in the policy rate even as retail deposit rates approached zero.”
Even below zero percent
Reserve Bank Chief Economist Yuong Ha, who is also a member of the Monetary Policy Committee, told Newsroom in an interview that the Reserve Bank would most likely tie the FLP rate closely to the OCR, or even make them the same.
“Ultimately, the outcome we’re trying to achieve is lower retail rates that the banks are going to pass on to their customers because that’s what will drive the positive cash flow effect for household and businesses — new borrowing. That’s the name of the game, to get more stimulus through lower rates,” Ha said.
“So we’ve always done it through an OCR. We’ve gone into LSAPs (bond buying) and we’re thinking: ‘what else do we have in the tool kit?’ and Funding For Lending is something that central banks around the world have done and there’s a track record of it working,” he said.
The bank was currently thinking it was unlikely to try to tie the funding to any particular type of lending.
“Historically they tended to start off with strings attached, saying you can get access to this money only if you lend to certain sectors or it does go out the door. What we’ve observed is that those conditions and strings have gradually been rolled back. It tends to be more effective if it’s just, you know, give simple clean access to cheap funding,” Ha said.
“And the other thing we’ve learned is that it can work nicely with the OCR. So you can tie the rate at which you lend to banks to the policy rate directly so it’s another way to shortcut directly lower funding costs for the banks.”
The Reserve Bank was still working on the details and had made no decisions about either the future OCR or the FLP rate, but Ha agreed it could be a negative rate.
“We would tie it close to the OCR because that’s the point. We want to lower funding costs. So we think this is why the package idea — that they work together. However we design it wouldn’t be in isolation (to the OCR). It would have full line of sight about how it would fit with a lower OCR or even a negative OCR,” he said.
“There’s no reason why we wouldn’t make it at the OCR as well. So it’s all about how would it be the most effective so when we go: ‘this is what we’re trying to do. We’re trying to lower rates’. We’re probably tying it to a lower OCR, potentially a negative OCR. And then what does the funding for lending program design look like to make the pass-through of the OCR effective.”
Focus on negative rates
Bank economists have changed their forecasts to factor in a negative OCR from early next year.
ANZ Chief Economist Sharon Zollner agreed that cuts in the OCR in conjunction with a FLP rate down as low as minus 0.75 percent would allow banks to drop fixed mortgage rates down to 1.5 percent.
“That’s the whole point, because of the floor on bank funding costs,” Zollner said.
“Deposit rates below zero? That won’t happen,” she said.
Zollner is now forecasting an OCR cut to minus 0.25 percent in April next year. Financial markets see cuts to minus 0.5 percent by August of 2021. ASB changed its forecast last week to a 75 basis point cut in April to minus 0.5 percent.
Wellington mortgage broker Andre Hutley also said a 100 basis point cut in the OCR to minus 0.75 percent could see mortgage rates drop towards 1.5 percent.
What would that do to house prices?
All other things being equal, a drop in mortgage rates to 1.5 percent would increase pressure on house prices.
The Reserve Bank itself did an analysis in its Financial Stability Report in November last year of how much 200 basis points worth of interest rate cuts between 2009 and 2019 had contributed to house price inflation. It estimated that across New Zealand this fall had increased house prices by about 50 percent.
A 100 basis point fall would increase house prices around 20 to 30 percent, as long as nothing else changed.
This chart from that November 2019 report shows the Reserve Bank’s ‘decomposition’ of the 80 percent rise in house prices in that 10 years.