What are the implications for this and how should those of us relying on term deposits be responding?

The Reserve Bank sets one of the key interest rates in the country known as the Official Cash Rate or OCR. This is the rate that the commercial banks receive from the Reserve Bank if they leave any money with them overnight, less 0.25%. If the banks are short at the end of each day they have to pay the Reserve Bank the OCR plus 0.25%. From there the commercial banks set the rates they offer for term deposits and what they charge for mortgage lending according to supply and demand and risk.

The banks do not necessarily pass all the changes in the OCR rate on to their lenders or borrowers every time the Reserve Bank changes it. What is more important to them is to make sure they don't lose market share to the other banks, so it all comes down to supply and demand. If a bank needs more funds from the public, they will offer a higher interest rate to attract that money, until they don't need any more money and they drop the rate back again.

The OCR sets the standard for very short-term over-night money and all the other terms follow on from there: 30-day, 90-day, 6-months and so on. Extra margin is also added on depending upon the risk involved or whether banking regulations are forcing banks to borrow locally rather than overseas.

To understand why the Reserve Bank is making interest rates go lower we must start with the role the Reserve Bank plays in the New Zealand economy. The Reserve Bank has a contract with the Government to keep inflation within a band of 1% to 3% per annum over the medium term. The focus is to keep inflation as close to the mid-point, 2% per annum, as possible. The Reserve Bank is also responsible for 'supporting maximum levels of sustainable employment within the New Zealand economy'.

What these roles are telling us is that a little bit of inflation is good for us, but too much is bad.

Got that? Good. But what do interest rates have to do with it?

If the Reserve Bank thinks that the economy is slowing down and inflation is likely to drop below that magical 2% per annum then it tries to speed it up, by lowering interest rates. By lowering interest rates, and assuming those lower interest rates are passed on to lower mortgage rates, it is increasing the money people and businesses with mortgages have to spend on other things. The money they no longer must spend on their mortgage can be spent in some other way. Some of this will get spent on things they have been putting off and, the Reserve Bank hopes, this will tend to support the prices of goods and services, helping inflation rise a little bit.

Another impact of falling interest rates is a corresponding drop in the value of the New Zealand dollar. When our interest rates fall compared to other countries investors around the world take their funds out of New Zealand and invest elsewhere. This makes the New Zealand dollar fall and this puts up the price of imported goods like petrol and diesel. This puts upward pressure on inflation so this is another way in which the Reserve Bank can impact inflation.

By the way, a falling New Zealand dollar increases the price of imported goods and decreases the price of exports, which is good for exporters. If overseas buyers are still prepared to pay the same in their currency our exporters receive more in New Zealand dollars (which helps them pay for the increased cost of imports!)

Is it working?

Hmmmm. To gauge this, we must look at indications of future business activity and expected demand for goods and services from people and businesses. This is measured in a number of ways, the key one being business confidence and business confidence has continued to fall for a number of months, even since the last 0.5% drop in the OCR.

One impact of such a large drop in official interest rates can be to spook people into thinking that the economy is worse than it actually is. People and businesses are meant to be encouraged to borrow when interest rates fall and thus stimulate the economy getting people spending more and nudging prices up a fraction.

Instead of increasing borrowing and investing into productive enterprise and stimulating the economy, the reverse could happen. People clam up fearful of taking advantage of the low interest rate opportunities. This has occurred in Australia recently where official interest rates are already at 0.5% per annum.

Many economists are of the mind that lowering interest rates any further will have less of an impact than usual as rates are already so low. They are saying that it is the job of government to stimulate the economy by handing out cash in some way that would have an immediate impact, such as tax cuts or even a cash distribution of some sort. At the very least, government could be spending on infrastructure although these projects have a long time in incubation while they go through the planning process.

How should we invest when bank term deposit rates are so low?

For the people living off bank term deposits it has been really hard watching their income fall over the past ten years. Sure, inflation has been low, so costs have not increased as much as in the previous ten years. After tax, the take-home income from term deposits is low, and falling.

What does the Reserve Bank say about this? They acknowledge the hardship that retired people are facing but point out that bank term deposits are not really investing. It is more like lending and getting someone else to take the risk (the bank) who become the real investor. The Reserve Bank suggests people think a bit harder about long-term investing and perhaps get professional advice.

Bank term deposits do not really compensate for inflation in that the capital return is agreed before the transaction takes place. Plus, all the return is taxed which is pretty inefficient.

Bank term deposits have their place as a temporary haven where one can park their funds, when one knows they will need all their cash intact in a relatively short space of time to spend on something else. An investment term of up to 3 or 4 years is probably best in a bank term deposit as the uncertainty over this relatively short period of time makes real investing in property or shares too much of a gamble.

Investing in property for the long term is the next place to consider, but again, I suggest that with property the real investor is the bank. You become the managing director of a business involved in commercial or residential real estate. You have to know what you are doing.

For a hands-off investment over the long term one can't beat listed property, bonds and shares - an internationally diversified investment portfolio - where the emphasis is on low cost funds employing a fully diversified coverage world-wide and keeping it simple. But you must pay for advice and monitoring, unless you are experienced and have the time to do it yourself.

To give you an indication as to what the expected real return (the return after tax, inflation and adviser/fund manager fees) of a term deposit vs a diversified portfolio of bonds, shares and listed property we have demonstrated this in the below chart

As you can see, the expected real return of 50/50 balanced portfolio is 2.6%pa vs a term deposit at 0.5%.... 5x the real return of a term deposit. Sure, the ride is bumpier, but you get compensated for the bumps over time.

Keep asking great questions ...