Economists used to talk about the “zero bound,” a supposed fundamental limit on lowering interest rates. But over the past few years one central bank after another has passed through the barrier with surprising ease, and set negative rates. The Bank of England, which was swift to adopt unconventional measures such as quantitative easing, has long resisted the policy. More recently, however, it has become more open to the idea and has been preparing the ground in case it might wish to go negative. If the Bank does follow its peers through the looking glass, what can we expect?
Such a move would be a first for the Bank in over three centuries. Look at the interest rates it has set since 1694, when they started at six per cent. They have never been negative. Even in response to the Great Depression of the early 1930s they fell only to two per cent. In the past decade or so they have plumbed new depths, dropping to 0.5 per cent in March 2009 following the financial crisis, and then to a further low of 0.25 per cent in the wake of the 2016 Brexit referendum. More recently, they fell from 0.75 per cent to a mere 0.1 per cent in March in response to the pandemic.
With interest rates now so low, you can see why the Bank’s policymakers have been contemplating a possible move into negative territory. This is, after all, no longer terra incognita. In July 2012, the Danish central bank led the way. That made few ripples in the water, but two years later there was a much bigger splash when the European Central Bank (ECB) adopted the policy. Not long after, the Swiss National Bank (SNB) followed suit, as did the Swedish Riksbank (which had already experimented with the idea in 2009-10).
If nothing else, these central bank pioneers have shown that the zero bound can be crossed. Rather than pay depositors interest, you can get them to pay you for holding their money. That had long been considered infeasible because there is a straightforward alternative in the form of cash, on which there is no such penalty. However, in practice holding banknotes has disadvantages, especially when the amounts are large.
Even so, no central bank has ventured far into the looking-glass world. The ECB tiptoed in, setting a rate of minus 0.1 per cent in June 2014, and since then has continued to take baby steps down to the current level of minus 0.5 per cent. The Bank of Japan has also adopted the policy, but has confined itself to a rate of minus 0.1 per cent, introduced in January 2016. The lowest that rates have been taken is minus 0.75 per cent, set by the Danish and Swiss central banks, and currently still in place in Switzerland.
There is a good reason why central banks have been cautious about going negative. Normally, cutting interest rates stimulates the economy by making it cheaper for households and businesses to borrow. But when further cuts turn rates negative, banks can face a squeeze on profitability that inhibits their capacity to lend. For one thing, they have to pay a levy on their own deposits with the central bank. For another, their profitability is further eroded if lending rates do fall but they are unable to bring down customer deposit rates in tandem. In practice, banks have been able to charge negative rates to companies but have been loath to do that with households.
A further worry about negative rates is their broader impact on businesses and households. It may be possible to go through the looking glass, but the landscape is disorienting. One reason why the Swedish Riksbank stepped back a year ago, pushing its main rate back up to zero, was concern that negative rates could come to be seen as permanent rather than a temporary measure. One of the Swedish rate-setters noted public disquiet about living in “the minus world.”
Despite such misgivings, negative rates do serve another purpose: they sway currency markets. Indeed the reason why the Danish central bank introduced negative rates in 2012 was to fend off upward pressure on the krone, which is pegged to the euro. Similarly, the SNB has deployed negative rates to try to curb the appreciation of the Swiss franc.
Developed economies have pledged to refrain from competitive devaluation. Shortly after becoming head of the ECB in late 2011, Mario Draghi cited a commitment by the G7 countries earlier that year for exchange rates to be determined by the markets. In his eight-year stint at the central bank, he repeatedly denied that the euro’s exchange rate was a policy target. But the decision to go negative in 2014 undoubtedly helped to push the euro down, when the underperforming eurozone economy needed all the stimulus it could get.
As the Bank of England weighs up whether to go negative, a crucial consideration will be what this might mean for sterling. When the pound plummeted following the referendum in June 2016, inflation rose sharply. That surge in prices eventually subsided but the pound has remained weak. Hopes of a trade deal with the European Union have been prompting a rise, but sterling is still well below its value at the start of 2016, especially against the euro. Negative interest rates may not be the right medicine for a country whose currency reflects the continuing self-harm inflicted by Brexit.
