Reserve Bank tightens the screws

Last week the Reserve Bank of New Zealand cut interest rates once again, to a new record low of 2 per cent for the official cash rate.

Will Rogers, an American cowboy, actor, author and newspaper columnist in the 1920s quipped:

"It isn't what we don't know that gives us trouble, it's what we know that ain't so."

Last week the Reserve Bank of New Zealand cut interest rates once again, to a new record low of 2 per cent for the official cash rate. In this, of course, they are not alone.

The Reserve Bank of Australia also cut rates to a new record low of 1.5 per cent at the beginning of the month, and some economists expect that rates in Australia and New Zealand will fall further still towards the zero mark seen in the large advanced economies.

Behind these extraordinary moves is a core belief that central bankers hold around how their actions impact the economy and inflation, in the jargon, the transmission channel of monetary policy. When interest rates are cut, the belief is that this will cause inflation to rise through two main channels.

The first "direct channel" is that it will cause the exchange rate to fall, which increases the price of imported goods and hence inflation. The second "indirect channel" is through boosting economic activity, including household and business spending, exports, and the fortunes of firms competing with imported goods and services. This overall lift in aggregate demand is expected to put upward pressure on inflation.

This orthodox view is beginning to be challenged, given how weak inflation and household spending remains globally, despite record low rates.

Recent OECD economic data shows household savings rates have in fact risen over the past year in countries such as Germany, Japan, Denmark, Switzerland and Sweden where interest rates are now zero or negative.

At the heart of the issue is whether cutting interest rates to very low levels in fact depresses household spending because of the negative impact it can have on savers and the retired. Instead of changing up a gear, has the car has been put into reverse?

When rates are extremely low it reduces the income streams from financial assets (e.g. bank term deposits, bond yields, and dividends). This means retirees relying on these income sources to support their retirement have less to live on and less to spend.

For savers looking to build a retirement nest egg low rates mean that they have to save more and for longer to build a sustainable income stream, reducing the amount they can spend today. In addition, low rates have boosted asset prices globally, which reduces the return that can be expected from financial assets in the future. Any financial adviser worth their salt will be cautioning clients that future returns are likely to be much lower than what has occurred over recent years.

For young savers looking to purchase their first home, low interest rates in New Zealand have been nothing short of a disaster. The rates cuts we have seen over the past year have no-doubt significantly contributed towards increased house prices - surely this is the elephant in the room regarding the "housing crisis".

The RBNZ has reacted to the financial stability risks from over-valued house prices by increasing required loan-to-value ratios. This means young savers have to save for longer to build a deposit in an environment where the return from saving is also lower. A double whammy impact on the amount of income they have left over to spend today.

From the RBNZ's perspective the discussion above is an "empirical issue" - interest rates are a blunt tool for managing aggregate demand and inflation, and how interest rates impact different sectors of the economy can't be fined-tuned. But as Will Rogers reminds us, assuming that rates cuts will always boost aggregate demand can create a lot of trouble if it ain't so.

- Aaron Drew is an Associate of the NZIER and Chief Investment Officer of the Stewart Financial Group, whose head office is in Hastings. His show Real Wealth can be heard on Radio Kidnappers on Tuesday afternoons and on podcast.