Sarah Basford* says Australia is inching closer to a negative interest rate so she looks at what that means for bank customers.
If you haven’t heard already, the Australian economy is in a bit of a slump with slowing growth and stagnating wages.
The Reserve Bank of Australia (RBA) is considering bold strategies to help alleviate the worsening situation — and it might result in Australians getting paid to borrow money via negative interest rates.
It’s all a bit confusing so here’s what we know.
What has the RBA said?
The RBA is Australia’s central bank and is responsible for the country’s economic prosperity.
It does this by “setting the cash rate to meet an agreed medium-term inflation target” while issuing the nation’s banknotes.
RBA Governor, Dr Philip Lowe told the Standing Committee on Economics in August the RBA was considering a number of possibilities, even “unconventional” ones to get the economy back on track.
“It’s possible that we end up at the zero lower bound,” Dr Lowe told the Committee, as reported by Business Insider Australia.
“I think it’s unlikely, but it is possible.”
“We are prepared to do unconventional things if the circumstances warranted it.”
“When we look overseas, we see some central banks have very low-interest rates and some countries have negative interest rates.”
“In Switzerland right now the interest rate is –0.75 per cent, in the euro area it’s –0.40 per cent and in Japan it’s –0.10.”
“So some central banks have gone negative.”
“That’s one possibility.”
Either way, Dr Lowe doubled down to say he was “expecting interest rates to stay low for a very long period of time”.
In a paper released this month by the Bank for International Settlements (BIS), Dr Lowe said unconventional monetary policy tools, like negative interest rates and quantitative easing, might be a solution to “crisis and the ensuing economic downturn”.
What does that mean?
Most of us have a vague understanding of how interest rates work.
If you have $10 in a bank account, a low interest rate of 1 per cent, for example, would mean your fortune (assuming you spend none of it) might grow by about 10 cents over the course of a year.
For growing your wealth, higher interest rates, say 5 per cent, are obviously preferable.
On the flipside, if you borrow money from a bank, a lower interest rate means you don’t have to pay much extra on top of your debt.
Say you took out a $50,000 loan and it had a fixed interest rate of 1 per cent, you’d pay around $42.47 per month.
This is because interest on a loan is usually calculated by multiplying the loan and the interest rate and then dividing by the number of the days in the year.
In this example, [(50,000 x 0.01) / 365] would equal $1.37 per day.
Multiply that number by the amount of days in a month (let’s say, 31) and it equals around $42.47 per month.
But Dr Lowe said the RBA was considering negative interest rates as seen in some central banks such as Switzerland and Japan.
This is where things get a little unusual.
With a negative interest rate, the opposite occurs.
Instead of gaining interest on amounts left in your bank account, you actually lose money.
Your $10 in the bank will lose 10 cents over the course of a year with a –1 per cent interest rate.
Conversely, you would earn money on any loan you borrow.
That $50,000 loan with a fixed interest rate of –1 per cent (for example’s sake) would likely earn you about $42.47 in interest per month.
This is what the RBA has suggested it’s considering as it would free up disposable income for Australians under financial pressure and give them more purchasing power, subsequently, stimulating the economy.
And what’s quantitative easing all about?
Dr Lowe also mentioned quantitative easing (QE) could be employed to sort out the messy situation in the BIS’s paper.
QE is when new money is printed by a central bank, like the RBA.
The RBA can then use that cash to purchase financial securities (like home mortgages or shares) and long-term, fixed-rate government bonds (essentially, a loan from the Government) and this, in turn, helps to maintain lower interest rates and the value of the Australian dollar over a longer period.
The paper pointed to England and Japan as examples where this policy helped ease the pressure of unconventional monetary policies.
“All four rounds of the BoE’s [Bank of England] QE were regarded as effective in influencing financial markets, albeit to different degrees,” the BIS paper outlined.
“The BoJ [Bank of Japan] programs have not led to higher inflation expectations despite creating extremely accommodative financial conditions and pushing up actual inflation and GDP [gross domestic product] to some extent.”
So, when can I see that money in my account?
Before you’ll see any money earned on your home loan, the RBA would first need to decree the negative interest rate policy.
Once that happens, commercial banks would then need to update their policies and then apply it to existing customers.
The RBA hasn’t specified when it might consider applying this “unconventional” method to stimulate the economy but with the way things are heading, it might be trying out a mixture of strategies sooner rather than later.
“We could reduce the cash rate down to a very low level, and it’s possible, if the circumstances warrant it, that we could take action to lower the risk-free rates further out along the term spectrum,” Dr Lowe said.
In Japan, the policy of negative interest rates hasn’t been all that successful, which is why the RBA isn’t ready to jump on putting this policy in place without testing other measures first.
It’s not yet clear what will happen in the immediate future but something’s got to budge.
* Sarah Basford writes for Lifehacker Australia. She tweets at @sbasfordcanales.
This article first appeared at www.lifehacker.com.au.
