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Should the Bank of England use negative interest rates in response to the crisis?

In the last decade, people in the UK have grown used to historically low interest rates. But imagine putting £100 in the bank and then, a year later, having £99 because your interest rate is negative 1%. Why might this happen, is it imminent, and would it help the economy?

Negative interest rates, though not currently used in the UK, are in use in other major economies including the euro area. The UK might follow these economies, even though there are no immediate signs that negative rates will be adopted.

At the Bank of England’s early August monetary policy press conference, Governor Andrew Bailey stated that negative policy rates are ‘in the toolbox… [but] we don’t have a plan to use them at the moment’ (Bailey, 2020a). In line with this, in a widely anticipated late August speech at Jackson Hole – the annual gathering of central bankers – Governor Bailey referred to ‘the possibility of negative rates’ but emphasised alternative policy instruments (Bailey, 2020b).

What does a negative policy rate mean in practice?

Cutting Bank Rate – the Bank of England’s official policy interest rate – would have been a conventional approach by which the Monetary Policy Committee (MPC) tried to support the economy through the current Covid-19 recession. Lower interest rates make it cheaper for companies and households to borrow, and by rewarding saving less, also give an incentive for households to spend rather than save.

But Bank Rate has been near zero for over a decade. In response to the 2007/08 global financial crisis, the Bank cut its policy rate by 5.25%. This time around, it has only managed a 0.65% cut: from 0.75% pre-Covid-19 to 0.1%. This is because the MPC has judged that its policy rate is at or near what is known as the ‘effective lower bound’ (ELB) – the point below which a further cut would no longer provide economic stimulus (Carney, 2019).

A negative interest rate policy would involve lowering official interest rates below zero. Since Bank Rate is the interest rate that commercial banks earn for holding cash reserves at the Bank of England, a negative Bank Rate practically means that those reserves are charged interest rather than earning interest.

Why would the Bank of England consider negative policy rates?

If the cut below the ELB would not provide a stimulus, why would the Bank of England ever consider such a policy? Determining the ELB is difficult because it is unobservable and must be estimated. It may also vary over time and is likely to depend on country-specific factors. During the 2007/08 global financial crisis, the MPC judged the ELB to be 0.5%. Since then, it has lowered its estimate to near zero.

Other central banks have judged the ELB to be below zero in their economies. The Danish and Swiss central banks have set their policy rates at negative 0.75%, the European Central Bank (ECB) and Swedish central bank have set negative 0.5%, and the Bank of Japan has set negative 0.1%.

Importantly though, even if the MPC has revised its judgement on the ELB to negative territory, it may still decide not to cut Bank Rate. The MPC has several alternative policy instruments at its disposal to stimulate the economy, including quantitative easing (QE) and forward guidance. Given the availability of these instruments – during the coronavirus pandemic, the Bank has already increased its asset purchases by over £300 billion – the decision on negative policy rates will depend on their comparative effectiveness relative to QE and forward guidance.

What might sway the Bank of England towards negative policy rates?

While there are both practical obstacles and concerns specific to the nature of the UK financial system, whether we will see negative policy rates in the UK will ultimately depend on the Bank of England’s judgement on the balance of costs and benefits of such a policy.

Primarily, this judgement centres on whether a negative policy rate erodes banks’ interest margins – hurting credit creation in the economy – or improves banks’ balance sheets by raising asset values – thus supporting credit creation. In either case, the transmission of the policy rate through the banking sector is key.

What determines the effectiveness of negative policy rates?

In normal times, commercial banks pass changes in Bank Rate on to interest rates on borrowing and saving faced by households and firms. Thus, a cut in the policy rate stimulates the economy through easing lending conditions and reducing incentives for saving.

The effectiveness of a negative Bank Rate depends on the structure of the financial system, in particular that the negative policy rate is transmitted as normal to the wider set of interest rates in the economy.

Why might the transmission of Bank Rate be different in negative territory?

The major difference between a cut in Bank Rate in positive territory and a cut that lowers the policy rate below zero is the transmission to household deposit interest rates. Usually, when Bank Rate falls, deposit rates fall as well. The international evidence, however, suggests that while some corporate deposit interest rates fell below zero when policy rates turned negative, household deposit rates rarely did (Heider et al, 2019). This might be explained by banks’ desire to maintain customer relations and households’ ability to hold cash (which earns a zero interest rate) rather than hold deposits at a bank and be charged for it.

If deposit rates remain positive, this may also weaken the pass-through of policy rates onto lending rates. Banks pay interest on deposits and earn interest on loans. If both a bank’s deposit and lending rates fall, then its interest margin is unchanged (all else equal).

If, however, its deposit rates are stuck at zero, then its interest margin and profitability may fall (since banks’ reserve assets are earning a lower return). To maintain their interest margins, banks may even increase interest rates on new lending and thus decrease credit creation, diminishing the stimulative effect of the negative rate policy (Eggertsson et al, 2019; de Groot and Haas, 2020; Sims and Wu, 2020).

Are there other transmission channels that need to be considered?

Interest margins are not the only way in which negative rates affect banks’ performance and the wider economy. A cut in policy rates also causes an increase in non-interest income for banks. As interest rates fall, the value of assets with fixed-rate coupon payments such as bonds increase. Equally, losses on outstanding loans typically decrease as borrowers find it easier to repay their debt. Depending on the balance sheet structure of the financial sector, this revaluation of assets can outweigh losses due to declining interest margins (Brunnermeier and Koby, 2019; Lopez et al, 2018).

In addition, given the Bank of England’s historical record of increasing interest rates incrementally, in a series of moderate steps, a negative rate policy may allow the Bank to signal a credible commitment to keeping policy looser for longer, thus lowering the entire term structure of nominal risk-free interest rates in the UK (de Groot and Haas, 2020).

This signalling effect might be particularly strong in the UK, where the introduction of negative rates would constitute a significant shift in policy. But a negative policy rate may also trigger pessimistic private sector beliefs about the state of the economy that counteract this effect (Glover, 2019).

Finally, it is worth pointing out that both negative policy rates and standard monetary policy changes affect different households differently depending on their type of income and wealth. For example, a reduction in interest rates can result in an income loss for savers holding interest-bearing assets (such as a retirees). In aggregate, however, evidence from the euro area suggests that a reduction in policy rates – if effective – compresses income inequality in the economy, largely because of the decrease in unemployment (Ampudia et al, 2018).

Furthermore, these distributional concerns of monetary policy are not explicitly a part of the Bank of England’s mandate, and the MPC will be likely to see it as the role of the government and fiscal policy to intervene if a subset of the population is made worse off by a prolonged period of low or negative interest rates.

Are there reasons why a negative policy rate might be less effective in the UK?

The reliance on deposits funding

Financial institutions more reliant on deposit funding are likely to be more adversely affected by negative policy rates. In the UK, these are building societies and smaller banks. More generally though, the UK financial system has increased its reliance on retail deposit funding since the financial crisis (Hill and Chiu, 2016).

Given this concern, the Bank of England could supplement the introduction of negative policy rates with an extension of its Term Funding Scheme (TFS) – an alternative source of funding for banks to support lending conditions – lowering the interest rate on the TFS to ensure that banks with a large deposit base still have access to cheap funding.

The existence of variable rate loans

Historically, the UK mortgage market issues a larger fraction of mortgages with variable rates (tied to Bank Rate) than the United States or other European countries. Thus, banks with a large existing portfolio of variable rate mortgages are likely to experience a sharper fall in their interest margins as a result of a negative policy rate. Over the last decade though, the stock of variable rate mortgages in the UK has decreased significantly (Cumming, 2019). This has contributed to a lowering of the ELB.

The amount of reserves holdings

Today, central bank reserves represent a significant fraction of the UK banking sector’s assets, not least due to the Bank of England’s QE programme over the past decade – exchanging private and public sector assets for perfectly safe and liquid central bank reserves (Vlieghe, 2020). But with the quantity of reserves growing, negative interest rates are likely to squeeze banks’ interest margins further. Given this concern, the Bank could follow other central banks by charging negative reserve rates only on a subset of reserves (European Central Bank, 2019).

In addition, there do not appear to be any immediate technical or political constraints on the Bank of England’s QE programme. This is different to the euro area, where asset purchases have been met by strong opposition by a number of member countries, which might explain the ECB’s early adoption of negative interest rates. Since the effects of QE are better understood these days, it seems likely that the MPC will continue to use this as its ‘marginal’ instrument of policy rather than breaking new ground.

Where does this leave us?

Negative policy rates – like all other monetary policy instruments – have costs and benefits. The precise balance of those costs and benefits remains uncertain, but evidence from other countries suggests that the costs are smaller than some critics of negative policy rates claim.

Our reading of the evidence is that negative interest rates have been effective in the countries in which they have been adopted. But there are sensible reasons, specific to the UK, for the Bank of England to be more cautious.

While the Bank’s latest announcements have dampened expectations of a move into negative territory, interest rates will remain structurally low – even in the absence of Covid-19 – and therefore the possibility of negative policy rates will remain a recurring agenda item for UK monetary policy. The Bank should thus provide clearer guidance on how and under what conditions negative interest rates might be implemented in the future.

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Authors: Oliver de Groot and Alexander Haas
Photo by Primrose from Pixabay
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