Under FLP, the Reserve Bank will pay banks to borrow if OCR goes negative

The Reserve Bank will end up paying banks to borrow from it under its funding for lending programme if, as many expect, the official cash rate turns negative next year.

In March, the central bank’s response to the Covid-19 pandemic was to slash its official cash rate (OCR) to its lowest ever point of 0.25 per cent, where it said it would remain for at least a year.

Subsequently, the bank instructed the commercial banks to prepare their systems for the possibility of the OCR going negative, should it be required.

Under the Reserve Bank’s funding for lending programme (FLP), which starts on Monday, the central bank will offer funding to banks at the current OCR rate.

The FLP interest rate will change if and when the OCR changes.

Some economists have rowed back on their forecasts of the OCR turning negative next year, but many still expect it to go into minus territory.

If the OCR goes negative, what happens?

“In that case, the interest rate on the FLP would also go negative,” Michael Gordon, senior economist at Westpac said.

“It would be done on a floating basis, so once the OCR changes then the interest rates on the FLP changes as well.

“The Reserve Bank would actually be paying the banks to borrow from that facility, which is a pretty strong incentive,” he said.

Gordon said many still struggled with the idea of negative interest rates.

“A lot of people don’t find it intuitive – the idea that the lender pays the borrower rather than the other way around – but it’s still a question of what price balances the market.

“The market for funding and loans is much the same as the market for any product.

“Demand and supply meet somewhere in the middle and it’s the price that balances them, and it’s possible for that price to be negative.”

Gordon used the example of earlier this year of when US oil futures prices went negative, because that was the price that balanced the market.

“Where we are at, at the moment, is that there is ample deposit money funding for banks already, and pretty weak demand for business borrowing.

“Deposits are still growing faster than lending, so that is telling you that supply of funds is exceeding demand.”

Even at the current rate of 0.25 per cent, the central bank’s FLP is a subsidy because it is lending at well below market rates.

“If you take the rate negative, it is just a larger subsidy,” Gordon said.

A spokesman for the Reserve Bank said funding for lending was purposely set as a floating OCR so that, if the monetary policy committee did decide to deploy a negative OCR, then this would get passed onto FLP borrowers.

Several economists expect the Reserve Bank to take its official cash rate negative some time next year, although some have moderated their views because of a more buoyant-than-expected economy.

Westpac expects 25 basis point OCR cuts in May and August next year, taking the rate to minus 0.25 per cent.

The bank had previously predicted that the OCR would reach minus 0.5 per cent by August.

ASB no longer sees a negative OCR as necessary, given the strong household response to date to low interest rates as well as the roll-out of the FLP.

“The FLP will help to keep a lid on bank funding costs, though against a backdrop of recent rebounds in wholesale interest rates as the hot housing market and the increasingly level of Government concern about housing get digested,” ASB said.

ANZ said its OCR forecast was predicated on a view that the economic recovery would stagnate to some degree early next year, and the Reserve Bank would eventually deem that more stimulus was needed, taking the OCR to 0.1 per cent in May and to minus 0.25 per cent in August.

Along with its low official cash rate and the funding for lending programme, the Reserve Bank has employed a Large Scale Asset Purchase programme – bond buying- which is aimed at lowering and flattening the wholesale interest rate curve.

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