Negative interest rates: The policy debate

Chris Smith

How are interest rates used in economic policy?

The Bank of England’s bank rate is an interest rate that is an influential lever of economic policy in the UK. It is the rate at which commercial banks borrow from the Bank of England, and is important because it affects other interest rates throughout the economy. These include mortgage rates and saving and borrowing rates available to households.

The Bank of England described how it uses changes in the bank rate to influence the economy. It set out how lower rates tend to increase spending and higher rates to reduce spending. Changes in the level of spending affect demand in the economy and therefore other variables, such as levels of employment and rates of inflation. Therefore, if the Bank judges that, for example, demand in the economy is too weak, it may cut interest rates to provide a stimulus.

At the start of 2008, prior to the financial crisis, the bank rate stood at 5.5%. By March 2009 it had been cut to 0.5%, and at the beginning of 2020 it stood at 0.75%. In response to the coronavirus, on 19 March 2020, the rate was cut to 0.1%, the lowest in the Bank of England’s 326 year history.

UK bank rate, 1975 to 2020, %

Graph showing UK bank base rate from 1975 to 2020

What do negative rates mean in practice?

In its August monetary report, the Bank of England set out what negative rates meant in practice. It stated that they would probably apply only to cash that banks deposited at the Bank of England, and possibly only to a proportion of that. Nevertheless, it said this approach would influence a “wide range of interest rates in the economy and borrowing costs in financial markets”.

The Bank argued that even with a negative bank rate, interest rates on household savings, and some commercial deposits, are unlikely to fall below zero. This is because individuals and some firms can withdraw savings from their bank accounts and hold cash “under the mattress” instead, avoiding the penalty of negative interest rates. Therefore, the argument suggests, banks would not offer negative rates to households and smaller firms.

What are their advantages?

Setting out the advantages of negative rates, the Bank said that in some respects they would stimulate the economy in the same way as other interest rate reductions. For example, they should encourage businesses to borrow and raise funds, or reduce cash holdings, both of which could increase investment. There should also be a depreciation of the exchange rate, boosting the competitiveness of exports. Any economic stimulus may also have a positive effect on banks’ profitability and capital reserves, through a reduced level of defaults on loans. This could encourage further lending.

In addition, the Bank described how negative rates will increase the value of assets by reducing the rate at which future earnings from them are discounted. This, it said, should mean that firms and households can raise money more cheaply, because they have more collateral.

What are the possible drawbacks?

The Bank of England also described how the effects of a cut below zero might not be as effective as previous reductions, and/or might have undesirable impacts on the financial system. It described a bank’s business model, in simplistic terms, as taking in deposits, on which it pays a certain interest rate, and then lending at a higher rate. The difference between the two rates is the bank’s profit margin. Bearing in mind that household savings rates (and many corporate deposit rates) are unlikely to fall below zero, as described above, the Bank of England described two possible ways in which banks might respond to the new environment. It said they might:

keep lending rates positive to retain profits. This blocks the transmission of falling rates into the wider economy, so the full effect of the cuts never occurs; or
reduce lending rates, thereby squeezing their profits and reducing their levels of capital. With lower capital, they may seek to reduce risk by cutting lending volumes—the opposite of the policy’s overall aim. This effect could be especially strong for smaller banks and building societies that are particularly reliant on retail deposits to back their lending.

Experience of other countries

The Governor of the Bank of England, Andrew Bailey, said that, in countries that have tried negative rates, the results have been a “mixed bag”. The August monetary policy report quoted Denmark, Sweden, Switzerland and Japan as countries that had implemented the policy. It said that its effectiveness depended on:

The stage of the economic cycle. For example, banks might choose to be particularly cautious in adverse economic conditions, when losses on loans are increasing. They are therefore more likely to reduce volumes of lending than to cut rates to encourage it. Noting the stresses caused by Covid-19, the Bank concluded that “implementing negative policy rates might be less effective in providing stimulus to the economy at the current juncture than at a time when banks’ balance sheets are improving”.
Structural features of the financial system. For example, the degree to which banks rely on retail deposits to back their lending, as opposed to other sources of funding (for example, the wholesale market). The Governor said that UK banks drew a relatively high proportion of their funding from to retail products. Therefore, the UK may be more likely to suffer the drawbacks associated with negative interest rates, as set out in the previous section.
How the policy is communicated. The Governor said that the public is likely to be “puzzled” by the policy, and it could affect firms’ and households’ confidence. If not explained carefully, this effect could further reduce its effectiveness in boosting the economy.

What is the Bank of England’s current position?

Given the above effects, Mr Bailey has said that negative interest rates were “not a straightforward policy tool”.

In May 2020, he set out the Bank’s position on negative interest rates in evidence to the House of Commons Treasury Committee. He said that the policy was being kept “under active review”, along with other tools of monetary policy such as quantitative easing, asset purchasing (for example, the Covid corporate financing facility) and forward guidance.

In September 2020, the Governor reiterated that negative rates were “something we should have in the toolbag as an option”. He added that work was ongoing to ensure that the tool could actually be implemented in practice if required, for example by removing technical limitations in banks’ IT systems.

The Bank also stated that it may be possible to implement variations on negative rates, to achieve better policy targeting. For example, it said that some central banks have introduced different base rates for different categories of bank deposits at the central bank. In addition, it noted that Covid-19 funding schemes may help to mitigate the drawbacks of negative rates, by providing funding directly linked to policy rates that can be passed on by banks to businesses.

Individual members of the Bank of England’s Monetary Policy Committee (MPC) have been interpreted as expressing different views for and against negative rates, leading some commentators to accuse the Bank of providing “mixed messages”. For example, external member Silvana Tenreyro was reported as saying that the evidence from other countries was “encouraging”.

However, Deputy Governor Dave Ramsden reiterated the view set out in the Bank’s August monetary policy report that “at present, negative policy rates would be less effective as a tool to stimulate the economy” than, for example, quantitative easing.

The Government itself has not commented on the subject of negative rates, stating that decisions on monetary policy, including the UK bank rate, were a matter for the Bank of England.

Comments

Many economists have argued that negative rates should not be introduced at the current time. For example, Professor Panicos O Demetriades of the University of Leicester stated that greater use of forward guidance was a better tool. He proposed that the Bank should make it clear that “rates will remain at the current low levels for the next two to three years”. He said this would encourage firms and households to borrow and spend.

However Professor Kenneth Rogoff of Harvard University (writing in an American context) argued for an “aggressive” policy of negative interest rates of -3% or lower. He said this would reduce the risk of bankruptcy for many firms and local government entities, and would also benefit developing economies. He suggested that the risks outlined above could be reduced by preventing financial firms, pension funds, and insurance companies from hoarding cash.