Negative Interest Rates Explained
When the RBA lowered the official cash rate from 0.25% to 0.1%, it was the first time the central bank had moved by a number other than 25 basis points.
It stands to reason that they broke with tradition because they didn’t want to land on 0%.
There are several reasons they may have done so, but it’s not because they can’t go to 0%. As a matter of fact they can go into negative territory.
A lot of regular people haven’t considered this a possibility. If interest rates went negative, then banks would be paying people to borrow money from them…it doesn’t make sense right?
Well, it’s all happened before. Sweden’s central bank cut to -0.25% in 2009; the European Central Bank cut to -0.1% in 2014 and Japan went negative just a few years ago.
Paying interest as we know it
Interest rates are basically the price you pay to borrow money. So if you had a 2% interest rate, and your loan was $100,000, you’d be paying $2000 in interest. So if you’re borrowing $100,000 for a year, you’re paying back $102,000. The principal is $100,000 and the interest is $2000.
In the past when the interest rate was 10% or 20%, you’d be paying $110,000 or $120,000 on that loan. If you took out that loan for 30 years, you’d be paying back hundreds of thousands of dollars. But that has completely flipped these days, the RBA has been lowering official rates year after year. In fact the last time they raised it was 11 years ago. Over the last 30 years the trajectory of rates have been going steadily downwards. On current trends, and considering the effects of pandemic lockdowns on the economy, it’s hard to see rates rising any time soon and they may even head into negative territory.
Why would central banks go negative?
The short answer is to stimulate the economy. Central banks need money to be loaned and spent to protect against further job losses and stop a deflationary spiral where people hoard money. When people stash their cash and don’t spend, prices come down. This encourages them to spend less again as they wait for prices to come down further and deflation sets in.
If the RBA went negative, it would offer lenders super cheap interest rates so those lenders could charge borrowers low rates and still make money. They are incentivised to lend and borrowers are incentivised to spend on assets. You are rewarded for investing by paying off loans at mega cheap levels, and you are punished for hoarding cash because you are the one who ends up paying the bank to store it for you rather than the other way round.
Keep the dollar on the downlow
Another reason to go negative is to keep the value of the Aussie dollar low. This will in theory deter foreign investors because of the low or negative yields on Australian debt and instead increase demand for exports from this country. That extra demand may allow Aussie businesses to expand and therefore help boost our economy.
Make the most of the situation
As an investor, you can use low to negative interest rates to acquire as much debt on quality assets as possible. Property is a great asset to do this with and has never been cheaper to pay off (though purchase prices are a different story). Accumulating property that will return rental income and build capital growth over time will help you make some money. If you simply sat on your cash however, you’d effectively be losing money every day. Not only are you paying for the privilege of keeping it in the bank, but inflation will do away with the rest of its value over time.