Economics

Negative interest rates could fuel unemployment

BY Jack Barnett   /  15 January 2021

The damage inflicted on the UK economy by the coronavirus pandemic and resulting lockdown measures has been enormous.

Traditional measures of the economy’s strength indicate the scale of the shock it has absorbed. The debt to GDP ratio now stands at 99.5 per cent, the highest since 1962. While output recovered over the summer, it is now contracting again, driven by the reintroduction of national lockdowns in parts of the UK.

The economy’s stagnation has made it incumbent on policymakers and central bankers to respond at speed and scale in an effort to protect peoples’ livelihoods.

Fiscal and monetary policy work in tandem

While Covid has caused immense harm to the economy, there is one positive that has emerged from the response to the crisis: fiscal and monetary policy are, finally, working in tandem. This is something that did not happen in the aftermath of the Financial Crisis, which resulted in scarring to the economy that was avoidable.

The government has deployed enormous support schemes, made possible by the Bank of England’s quantitative easing programme putting downward pressure on interest rates. QE has kept debt servicing costs low by putting a floor under bond markets, which has allowed the Government to find buyers for extremely low-rated gilts.

However, monetary policy now has little room to manoeuvre. Beyond QE, the Bank is limited to using interest rates as a lever to stimulate the economy.

The Bank rate currently stands at a record low of 0.1%. Any further reductions will likely send it into negative territory. Greater consideration is being given to this action, partly because the Bank does not have any alternative.

Bailey faces stark choice over negative rates

Deciding whether to set negative interest rates is the biggest challenge facing the Governor of the Bank of England this year as doing so may produce unintended outcomes that curb the UK’s economic recovery from the pandemic.

Besides the fact they have never been implemented in the UK and strong misgivings about how the financial system would cope, negative rates are likely to have an adverse impact on household consumption.

If rates are plunged into negative territory, households may increase monthly savings contributions due to receiving smaller returns on their savings accounts. As a result, consumer spending would diminish, reducing businesses’ income in the process.

Weakened household consumption would compound the revenue hits firms have absorbed during the pandemic, possibly resulting in business confidence dropping and fuelling even greater reluctance to hire new workers.

Betting on consumption bounce back is fraught with risk

Some would argue negative rates would expand the availability of credit by incentivising banks to lend and keeping borrowing costs low. This would provide a welcomed boost to firms’ cash flow, strengthening their medium-term outlook and possibly encouraging them to invest.

However, company balance sheets are currently awash with debt due to the shutting down of large swathes of the economy, forcing businesses to borrow to survive. A further reduction in rates may encourage firms to add to their pandemic-induced debt pile, prompted by having access to cheaper financing.

This would put a lot of pressure on relying on a sharp bounce back in consumer spending in 2021.

If consumption does not fully rebound, firms may not be able to service a high proportion of debt due to a reduction in revenue. It seems even more likely households may spend less in a negative interest rate environment as they top up their savings by more than usual to offset lower interest income.

This would all amalgamate to hit firms’ bottom lines and sour the wider businesses climate. They could then renege on new hires or even enact staff shake-outs to align their cost base with reduced demand, driving up unemployment.

Andrew Bailey should pay less attention to meeting the Bank of England’s 2% inflation target when deciding whether to introduce negative interest rates. High inflation is not the worst potential outcome resulting from a negative interest rate environment – higher unemployment is.

 

Jack Barnett is a Senior Account Executive at Instinctif Partners, an international business communications consultancy.


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