The unprecedented circumstances we find ourselves in call for extraordinary measures. The severe, and still unravelling, economic downturn caused by the coronavirus epidemic requires special remedies, some not tried out before. Andrew Bailey, Governor of the Bank of England since March 2020, thus informed the Treasury Select Committee on 20 May 2020 that negative interest rates were under “active review” by the central bank. The need to consider such an unconventional, and largely unproven, monetary policy tool only highlights the desperate depths to which the British economy appears to be heading.
In this context, a negative interest rate refers specifically to interest charges placed on cash deposits held by commercial banks at the Bank of England. If implemented, interest rates will enter negative territory for the first time in the UK, dropping below the usual “lower bound” of interest rates, which is set at zero per cent. This means that commercial banks will be charged fees for, instead of earning interest from, depositing their cash reserves with the central bank. Rather than hoarding cash during challenging times, commercial banks will be encouraged to lend to both households and businesses. Increased borrowing, spending and investment will then go on to stimulate a flailing economy, boosting economic growth by what are essentially financial means. At least, that’s the theory.
Negative interest rate are, however, both unconventional and counterintuitive. Savers are penalised, while it is attractive to be a borrower, even when it can be risky to borrow. This increased lending can potentially stimulate demand for cash-like assets, causing asset bubbles, associated with unmanageable levels of debt.
Negative interest rates are a relatively new monetary policy tool, part of the central bank’s economic toolkit aimed at maintaining a low and stable inflation target of 2 per cent. Inflation, manifested by rising prices for goods and services, implies reduced purchasing power and an increased cost of living. This undoubtedly harms the economy. But then so does deflation. A deflationary spiral results when falling prices lead to lower production, reduced business profits, lower wages, rising unemployment. lower demand, and a further fall in prices. Monetary policy is designed to keep inflation at a sustainable level, thereby encouraging the consumption of goods and services while contributing to economic growth.
The global financial crisis of 2008 was followed by a range of monetary policy interventions in the economy by central banks, seeking to control both the price of money (interest rates) and the quantity of money, including the supply of new money. Interest rate manipulations are particularly important, as they strongly influence borrowing, saving and spending decisions. Ultra-low interest rates became the norm, and negative interest rates soon followed . The central bank of Denmark was the first to turn to negative interest rates in 2012, followed by the European Central Bank (banker for the 19-member Eurozone) in 2014, and the Bank of Japan in 2016. It is hard to quantify the benefits of such an approach, or to even know if there was any actual benefit at all. Not only that, but as increasing numbers of central banks are tempted to enter the fray, currency devaluations may lead to a competitive war between nations. Ultra-low interest rates may also distort financial markets and destroy the stability of insurance and pension funds.
The threat of negative interest rates is a particular source of worry for households with savings deposits that are held in commercial banks and building societies. However, it seems unlikely that high street banks will pass on negative rates to their retail customers. What is more likely is that interest rates will flatline at the zero per cent level, which means that savings will not generate any returns at all. Negative interest rates for retail customers will only lead to large scale cash withdrawals from banks, with bank runs caused by mass panic withdrawals a distinct possibility. Another worry for many relates to mortgage repayments. When it comes to mortgages, negative interest rates will not affect repayments for fixed-rate mortgages, while repayments on variable-rate mortgages may fall by a small amount.
In times of economic crisis, central banks are expected to actively intervene, to nurse damaged economies back to financial health. Unfortunately, some potential interventions are largely untested or unproven. There remains the risk that monetary policy tools may lead to undesirable consequences, and this includes negative interest rates.
Ashis Banerjee