The Australian economy looks to have avoided a worst-case outcome, but with more than 1.5 million people officially unemployed and many more supported by JobKeeper, the road to recovery will require bold action.
One suggestion has been reducing the RBA cash rate below zero. Notwithstanding the logistical and implementation issues with such a move, we are skeptical of the ability of negative interest rates to support a sustainable economic recovery.
In theory, very low (or negative) interest rates make borrowing more affordable and incentivise savers to increase consumption. Real world evidence suggests, however, that unintended consequences arise when interest rates are turned on their head.
Several European countries have had negative interest rates for some time, with mixed results. Existing borrowers have undoubtedly seen their interest burdens decline, but savers have interpreted the measure more cautiously, evidenced by the continued increase of bank deposits despite the deeply unattractive interest rate. The continued demand for government bonds with negative yields to maturity shows that it is not just retail investors that are grappling with this most unconventional of situations.
Other challenges have included:
- Forcing savers that do not wish to increase consumption to consider higher risk assets that increase the possibility of capital volatility or loss.
- Falling bank incomes as lending becomes less profitable, impacting the ability to pay dividends to shareholders.
- Artificially inflating asset prices (including residential property), which can create inequality by disproportionately helping asset owners at the expense of other members of society.
While we believe that the Reserve Bank will not implement negative rates, many local investors are already facing the challenges listed above. Furthermore, because Australian households are highly indebted by world standards, the ability to take advantage of cheap borrowing rates is limited.
In conclusion, interest rates are set to remain pinned close to zero for some time yet. While actual negative rates would pose additional challenges, the current stance will nevertheless impact some parts of society differently to others.
Clearly, the implications for investors are about preserving capital while creating income sufficient for their needs. Just as courageous policy action is required to support the economic recovery, bold decisions by investors will need to be made in the months and years ahead.