Why negative interest rates wouldn’t help the UK economy

Will the Bank of England soon join the European Central Bank (ECB) and the Bank of Japan in taking its official interest rate into negative territory? Speculation was fuelled a few weeks ago when the Bank wrote to financial institutions asking them how they might implement such a policy, if it were put in place.

The idea of negative interest rates seems perverse. Surely savers should receive a positive return on money they invest with a bank and borrowers should pay a reasonable interest charge on their loans? But since the Global Financial Crisis, we have been living in a world where the normal rules of finance don’t always apply.

We have already had a negative real interest rate in the UK for over a decade. The official Bank Rate has fluctuated between 0.1 per cent and 0.75 per cent, compared with an inflation target of 2 per cent and actual CPI inflation averaging just above that figure.

However, the Governor of the Bank of England Andrew Bailey has refused to rule out setting the official Bank Rate below zero for the first time in the UK. He describes a negative interest rate as part of the “monetary tool kit,” though not one that the Bank’s Monetary Policy Committee is yet ready to deploy.

So what kind of tool is it? Europe and Japan have had a negative interest rate since the mid-2010s. It applies to deposits held by commercial banks with the central bank. In the case of the ECB the rate is -0.5 per cent and in Japan it is -0.1 per cent.

The rationale behind this policy is to encourage the private sector banks to lend out money at positive interest rates to their business customers and individuals, rather than keeping money on deposit with the central bank. This might be a legitimate argument if the cautious behaviour of banks was the main impediment to lending in the economy at the moment.

However, in the pandemic, the main impediment to normal lending is the massive shock to the economy and the way this has disrupted business activity and the financial prospects of households. This has increased the risks attached to all types of lending, and borrowers have become much more cautious as their financial prospects have become much less secure. The UK government has already stepped in with various initiatives to support and encourage lending in this more risky economic environment.

Given this massive increase in the risks attached to lending, a small downward adjustment in the official interest rate from its current level of 0.1 per cent to -0.1 per cent (as in Japan) or -0.5 per cent (as in the eurozone) is unlikely to make much difference to bank behaviour. Indeed, it could make the situation worse. A negative interest rate is a tax on the banking sector which dents profits and reduces financial resilience.

There are other problems that negative rates could create or exacerbate. Savers have struggled to find adequate returns on their investments. The returns available to pension funds have been badly hit. Many economists believe that prolonged near-zero interest rates have already 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.

Negative interest rates also 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. Yet erosion in the value of money is why we have used monetary policy to combat high inflation in the past. It would be perverse if negative rates were used to erode the value of deposits as an act of deliberate policy.

Another consideration is the impact on the value of sterling. One of the reasons that a number of central banks 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 very weak by historical standards, partly due to Brexit concerns.

For all these reasons, a policy of negative interest rates would undermine the resilience of the UK economy, rather than helping us deal with the economic fallout from coronavirus.

With interest rates at near-zero levels for over a decade now, monetary policy has done as much as it can to support economic growth and may have already set in train some perverse economic effects. We need to look to other levers of policy to support the economy through the current crisis—effective public health measures and further tax and spending policies which aim to protect the worst affected businesses and safeguard jobs.

I have a vision of Bailey sitting at his Governor’s desk. In his “pending” tray is an official briefing document on negative interest rates and how they might be implemented. He should leave it there. Or even better, he should return it to the filing cabinet of rejected policy proposals, where it belongs.