Negative interest rates and their possible implementation in the UK

In 2009, the Swedish Riksbank became the first central bank this century to introduce a policy of negative rates, realised in response to the liquidity shortage exposed by the money-market crisis of the financial crash.  Since then, the European central Bank (ECB) and the Bank of Japan (BOJ) have emulated Sweden’s monetary policy expansion in 2014 and 2016 respectively. Currently, the ECB’s interest rate for deposits stands at minus 50 basis points, whilst the BOJ’s remains marginally higher at minus 10.

To commence the implementation of negative rates, a central bank, such as the Bank of England (BOE), must initially lower its base rate below the threshold of 0%. As a result of this rate cut, commercial banks become obliged to pay the BOE to deposit holdings, prompting these banks to filter the cost through the economy unto their own private depositors. The ultimate outcome would therefore be a situation of contemporaneous interest charges on savers and negative yields in the gilts market, fomenting disquiet amongst investors in government bonds.  Theoretically, once negative interest rates set in, economic growth should be spurred by a significant reduction in households’ marginal propensity to save, alongside firms’ heightened abilities to borrow from commercial banks.

Moreover, a fall in bond yields amplifies the effect of financial repression, as government debt decreases more rapidly in real terms.  If one considers this in conjunction with the likely devaluation of a nation’s currency, it becomes easier to understand how negative rates may promote export-driven growth and an improvement of both current account and budget deficits. This is perhaps why President Trump has labelled the policy tool a ‘gift’, which would help the US compete internationally against Chinese exports.

Nevertheless, despite the policy’s theoretical application, Jacques de Larosière, a former IMF managing director and governor of the bank of France, has a series of concerns with its implementation. He suggests that there are two significant ways in which negative rates can slow down the economy. Firstly, any policy measure designed to discourage saving may create a liquidity trap, whereby households possess no incentive to deposit money in bank accounts, denying banks of loanable capital. Secondly, data from Statista demonstrates low and stagnant growth in UK bank’s profitability since 2015. Were rates to further fall, the profitability of major banks may be squeezed increasingly more, inhibiting credit provision. Both of these aforementioned reasons have the potential to diminish aggregate demand, as the economy declines unnecessarily.

Recent academic research by economists Markus Brunnermeier and Yann Koby has also identified that a reduction in interest rates beyond zero will not be economically stimulating in perpetuity. They describe the ‘reversal rate’ as the ‘rate at which accommodative monetary policy reverses its effect and becomes contractionary for lending’. The determination of the rate depends on several factors regarding the structure of a nation’s banking system; however their research resolutely indicated that quantitative easing tends to increase the reversal rate by means of removing long-term fixed income holdings from bank’s balance sheets.

In spite of these theoretical concerns, data published this year from the ECB illustrates a demonstrable uptick in the profitability of European banks since 2014. It appears that the squeeze on bank margins was mitigated by a reduced number of defaults, as the policy of negative rates has intuitively made a greater number of debtors credit-worthy. Thus far, negative rates have appeared to foment growth for Eurozone members, yet even among some of the policy’s strongest proponents, central bankers like those at the Riksbank remain apprehensive to maintain interest rates below zero for too long. An extended low interest rate environment may be helpful in relation to government debt, but its implications on savers, investors and retirees with pension funds are highly damaging.

In the UK, governor of the BOE, Andrew Bailey, has admitted that the proposal for interest rates to turn negative is currently under ‘active review’.  However, his previous condemnation of the monetary tool suggests that the bank is unlikely to hastily impose the measure without a calculated consideration of all other policy options available. Interestingly, gilt yields for maturities up to five years are currently trading below zero, highlighting that for some investors, the implementation of negative interest rates in the UK is not a matter of if, but when.

 

By Joshua Chapman

Senior Editor: James Float

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