Resist the siren song of negative interest rates

Andrew Bailey, who recently took up his new post as Governor of the Bank of England, has caused a stir by speculating about the possibility of negative interest rates arriving in the UK. He told a parliamentary committee that it would be “foolish” to rule out such a policy. His colleague Andy Haldane—the Bank’s Chief Economist—has been musing publicly along the same lines.

Japan, the eurozone, Switzerland, Sweden and Denmark have all introduced negative rates in some form over the past decade. President Trump has occasionally advocated a similar policy for the United States. So should the Bank of England be following the same path?

In one sense, this is not such a radical departure. Here in the UK interest rates have been negative in real terms—ie adjusted for inflation—since 2009. Since the official Bank Rate was cut to 0.5 per cent in March 2009, the average official borrowing rate has also averaged 0.5 per cent while inflation has been 2.3 per cent. That is a negative real interest rate of nearly 2 per cent.

However, this policy of negative real interest rates has already provided a foretaste of the problems which a headline below-zero rate could bring. Savers have struggled to find adequate returns on their investments. The returns available to pension funds have been badly hit. And many economists believe that prolonged near-zero rates have blunted the incentive for businesses to look for efficiency improvements—contributing to low productivity growth.

These problems would all be reinforced if the headline interest rate actually went negative. But there are some powerful additional arguments against this policy.

First, it would undermine one of the traditional roles of money in society—as a store of value. In a negative interest rate world, money held on deposit erodes in value year by year. The erosion in the value of money is a key reason why we have become so averse to inflation. So it would be perverse to institutionalise the erosion as a deliberate policy.

Second, it is far from clear that a policy of negative rates would be effective in stimulating the economy—which is normally the main reason for cutting them. In Japan and the eurozone there is evidence that negative interest rates have eroded business and consumer confidence, rather than restoring it. When the central bank takes such a dramatic and unusual step it can easily heighten the sense of worry about economic prospects, rather than allaying it.

Third, one of the reasons that a number of countries and the eurozone have embraced negative rates has been to hold down the value of the currency. That is not needed here in the UK, where the pound has been weak by historical standards, not excessively strong.

Finally, a negative interest rate undermines the health of the financial system—by forcing banks to pay interest on deposits they hold with the central bank. After spending a decade repairing bank finances in the aftermath of the financial crisis, it would be perverse to embark on a policy which starts to weaken them.

For all these reasons, negative interest rates would undermine the resilience of the UK economy, rather than helping us deal with the economic shock created by the current pandemic. So if the arguments are stacked against such a policy here in the UK, what else should the Bank of England be considering to support the recovery of the economy as it emerges from lockdown?

Aside from changing the level of interest rate, the other main monetary instrument available to the Bank of England is Quantitative Easing (QE)—purchases of government bonds and other financial assets. A couple of months ago, the Bank’s Monetary Policy Committee agreed to inject a further £210bn of QE into the economy to cushion the blow of the coronavirus pandemic. When this programme is fully implemented, it will take the total Bank holding of government bonds to £645bn—over a third of the UK’s national debt.

The Office for Budget Responsibility is projecting a total UK deficit of close to £300bn in the current financial year. The latest injection of QE will mean that the Bank of England is financing around 70 per cent of this new borrowing. What this effectively means is that the Bank is printing money to finance the bulk of the government deficit, a policy which many economists believe could lead to inflation.

While the Bank should not rule out more QE if it proves necessary to oil the wheels of recovery, for now the best policy appears to be “masterly inactivity.” Keep interest rates at the current rock-bottom level of 0.1 per cent, and observe how the unlocking of the economy proceeds.

But with rates at near-zero levels for over a decade now, and currently at the lowest level in recorded history, monetary policy may have done as much as it can to support economic growth and may have already set in train some perverse effects.

The main policy levers for supporting the economy at present lie with fiscal policy—tax and spend measures. The Bank of England should resist the temptation to experiment with negative interest rates when most of the evidence suggests that they have provided little help for the economies which have tried them.

Andrew Sentance, senior adviser, Cambridge Econometrics and former member of the Bank of England’s Monetary Policy Committee