The Australian share market declined by 2.2% in the month of October, closing at 5,402.4 points. The Australian Dollar declined by 0.8% for the month, with 1 Australian Dollar currently buying 76.1 US cents.
Global investment markets were mixed in October. The US Dow Jones Index fell 0.9%, the London FTSE gained 0.8%, the Japan Nikkei 225 gained 5.9% and the Hong Kong Hang Seng Index fell 1.6% in the month.
Just before the racing of the Melbourne Cup later today, the Reserve Bank (RBA) board will meet to assess interest rates. After keeping the official Cash Rate on hold at 1.50% per annum in October, a higher than forecast inflation result in the month has resulted in most economists' expectations for interest rates to remain on hold once again.
Although domestic interest rates are expected to remain on hold today, central banks around the world have been adopting unconventional monetary policy in an effort to stimulate their economies. This has resulted in use of negative interest rates in certain economies, however is this good policy? Do negative interest rates really stimulate an economy?
Negative rates refer to interest rates set by central banks at less than 0%. The chart below shows countries adopting this approach to monetary policy.
Negative interest rates have only ever been observed once before, and that was during the Global Financial Crisis (in a limited capacity only) and were not seen even during the Great Depression. For now, negative interest rates apply only to banks' deposits (also known as 'reserves') at the central bank in Sweden, Denmark, Switzerland, Europe and Japan.
As the negative interest rates for the aforementioned economies applies to reserves only, the negative interest rates act as a 'tax' on banks that hold reserves with the central bank. Consequently, banks now need to seek other ways of generating income to offset this tax if they are to maintain their profits.
Banks can generate profits in various ways, although an obvious way to maintain profits when faced with a negative interest rate tax is to reduce the rates that you pay to deposit holders (or increase the interest rate that you charge borrowers).
Both of the above measures don't help simulate an economy – as both borrowers and deposit holders have less money available to spend in the economy (i.e. this restricts economic growth).
The theory of low interest rates (or negative interest rates for that matter) is to encourage business spending via borrowing to invest in capital expenditure – which, in turn, will lead to more employment and greater economic output. However, history suggests that corporate capital expenditure decisions are more closely focussed on expectations of future income, rather than borrowing cost.
For instance, if you are planning to purchase a business, you would spend the majority of your time assessing the revenue from that business (who are your customers, what makes the business products appealing to those customers and how can the business attract more customers into the future). While you would also assess the costs of that business, the borrowing cost is only a minor aspect of the overall purchase decision.
The contrary applies to housing decisions. As you don't generate any income from your primary residence, you primarily focus on borrowing cost when making a purchase decision (i.e. your monthly mortgage repayment over your acceptable borrowing term).
The evidence, in Sydney in particular, is that low interest rates have simulated the property market greatly (which granted does have some flow on effects to the broader economy), with limited non-property or government related infrastructure capital expenditure taking place.
I am sure that the central bank theories of this somewhat radical approach to monetary policy (with low interest rates) was not to stimulate property prices, rather it was to stimulate economic output. Nor was the theory for households to absorb record levels of household debt.
The challenge for the RBA board now is to know when (or how) to alter its course of monetary policy, without causing a major hiccup in asset values (and while trying to support its stance of wanting a low Australian Dollar to benefit export and tourism markets).
For more information, please contact Ryan Love or Michael Clapham on 1300 856 338.
This article is general information only and is not intended to be a recommendation. We strongly recommend you seek advice from your financial adviser as to whether this information is appropriate to your needs, financial situation and investment objectives.