A personal view from Ian Stewart, Deloitte’s Chief Economist in the UK. To subscribe and/or view previous editions just google “Deloitte Monday Briefing”.
Data released on Friday showed that the UK economy contracted by more than 26% in March and April as the lockdown collapsed activity. The governor of the Bank of England (BoE), Andrew Bailey, responded by saying that the Bank stood “ready to take action” to help the economy as it emerges from the lockdown. This week we consider whether the time has come for the Bank to deploy the big gun in its arsenal, negative interest rates.
At the onset of the crisis, the BoE cut the base rate to 0.1% from 0.75%. Last month the governor, Andrew Bailey, said negative rates were “under active review” for the first time in the Bank’s 324-year history. In the US Donald Trump, a long-time advocate of cheap money, tweeted the US should accept the “GIFT” of negative interest rates.
Markets are alive to the possibility that UK rates could drop into negative territory. Last month futures markets briefly priced in interest rates turning negative by December. And, for the first time, three-year government gilts were sold at a negative yield, meaning investors were paying the government to hold its debt.
Interest rates have drifted lower over the last ten years as central banks have attempted to stimulate growth in the wake of the global financial crisis. In 2014 the European Central Bank (ECB) set interest rates below zero for the first time. It did so in an attempt to stop the euro area falling into a deflationary spiral. The Bank of Japan followed suit in 2016.
In this seemingly upside-down world, private sector banks must pay the central bank to keep their money. The aim is to encourage banks to increase lending. Central banks want to force cash out of bank reserves and put it to work in the economy.
In the absence of a counterfactual it is impossible to be certain that negative interest rates have worked as intended. An ECB paper published last month argued that negative rates have contributed to an increase in lending volumes and the improvement of the creditworthiness of borrowers. Bank lending, which was shrinking when the ECB first cut rates below zero in 2014, has since rebounded. The ECB estimates negative interest rates have boosted loan growth by around 0.7 percentage points each year.
But, like any untested policy, the effects of negative interest rates are not well understood and unlikely to be wholly benign. The risk of unintended consequences is high.
Sweden’s central bank recently reversed its negative rate policy to avoid the perception that negative rates were here to stay – and the risk that such a view would dampen confidence and activity.
But the main risk associated with negative rates relates to their effect on the banking sector. The policy leaves banks paying – rather than receiving – interest on their deposits with the central bank. Banks also struggle to pass on negative rates to households, as savers may respond by holding on to their cash rather than paying a penalty to keep it the bank. The danger is that negative rates squeeze bank profits and their capacity to lend. Negative yielding government bonds, a by-product of negative interest rates, also challenge the profitability of pension funds and insurance firms.
Critics of negative rates focus on the so-called ‘reversal rate’, the interest rate below which policy goes from stimulating growth to reducing it. This occurs when negative rates squeeze banks’ profit margins to such an extent that they reduce lending to households and businesses.
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The Association of German Banks said in a recent report that negative rates had cost euro area lenders a total of €25bn commenting, “this burden is depressing the profitability of the banks and will ultimately even constrain their lending capacity”.
The ECB rebuffs this idea. It says that negative rates also help banks through lower financing costs, reduced provisions for bad loans, increased demand for credit and a rise in the value of debt securities held by banks.
Many of the criticisms of low interest rates and quantitative easing also apply to negative rates. Easier monetary policy makes it difficult or impossible for savers to generate income. Investors have to take more risk to ensure same level of return. This “search for yield” creates a danger of a boom, bust cycle in risky assets. It is just such risk-seeking behaviour which helped cause the financial crisis.
The risks associated with negative rates suggest that before deploying them the authorities would want, first, to deploy existing tools more aggressively. That would mean an expansion of its programme of quantitative easing which, at the onset of the COVID-19 epidemic, was more than tripled in scale to £645bn. There has been some speculation that BoE will announce a further £100bn expansion at Thursday’s Monetary Policy Committee (MPC) meeting. That would be sufficient for the BoE to continue buying bonds at its current pace until August, when the MPC is next due to meet.
Other central banks have acted in similar fashion. Last week the ECB expanded its Pandemic Emergency Purchase Programme, the extra bond buying programme it launched in June, by €600bn to €1.35tn, and extended it until at least June 2021.The US Federal Reserve has also increased its asset purchases, and in March it announced plans to include corporate bonds in its quantitative easing programme.
Further fiscal stimulus is likely. Last week the German government launched a huge post-COVID stimulus package, worth €130bn, with extra spending, tax cuts and help to business. The UK Treasury said it is considering announcing a further package of measures to support the economy in July, with more substantial stimulus likely in the autumn.
It is sign of the times that negative interest rates are under consideration at the BoE. Yet the uncertainties around their longer-term consequences remain. UK policymakers are likely to exhaust existing policy tools before pushing rates below zero. Were the outlook to worsen the balance of argument on negative rates could shift – with the BoE following the ECB deeper into unconventional territory.