The negatives and positives of negative interest rates

Negative interest rates have made more headlines this year than a normal Love Island summer series.

The past week has been no different after the Bank of England said on Thursday it had begun dialogue with the Prudential Regulation Authority about how negative rates might be implemented in quarter four.

So what’s the big deal and why are economists so petrified about the Old Lady taking the plunge. The debate will rage on for some time but one thing is for sure the Bank of England’s tool box is looking increasingly empty.

Here the Evening Standard looks at some positives and negatives:

  1. Psychological
    The UK has had real negative interest rates for a long time. Essentially anyone saving in a standard current account would have seen the value of their money go down because nominal interest rates are below the level of inflation. This has been the case for government debt and household deposits over the past ten years.

If nominal rates went negative the banks would be likely to pass this on and savers would lose out further. But this is not a new problem.

  1. Old days are gone
    The argument that we need to get back to the old ways of central banking has gone. Monetary policy has been so skewed over the past twenty years that central banks purchasing assets – otherwise known as quantitative easing – has become normal.

Yes in an ideal world the UK economy should be moving towards higher rates and a 2% inflation target but as the old Bank Governor Mark Carney found out even when things are good this is hard to implement.

  1. Coronavirus
    To get out of this mess lending will have to be encouraged. The easiest way to do this is to make money and the rate it is loaned at as cheap as possible.

It would also make getting rid of current debt easier, in particular mortgage repayments.

  1. Armageddon
    The biggest fear is the unknown. But there is no evidence that Armageddon would take place. Evidence from Switzerland, Denmark, Japan, Sweden and the European Union where negative interest rates have been introduced show the policy has been effective.

Likewise, when quantitative easing was introduced in 2009, economists predicted Weimar Republic style hyperinflation. None of that took place.

  1. Boost for manufacturing
    Below zero rates would see a depreciation in the exchange rate, as international investors would sell off UK assets when rates go negative.

This would in turn boost the UK’s manufacturing sector as a weaker pound should make exports cheaper.

  1. Improve bank balance sheets
    As we have seen in the Euro area some bank balance sheets have been improved and profitability increased as banks have found it easier to lend to businesses.

Negative interest rates bring additional loosening of monetary policy which can improve the macroeconomic outlook.

Improved prospects for the real economy should reduce the amount of impaired loans, boosting bank’s profitability.

The resulting increase should be enough to offset the impact from reduced interest income.

But the flip side of declining interest could also be bank’s reducing lending, particularly if they are worried about maintaining their capital ratios.

When activity in the economy is falling, and unemployment is rising, losses on banks’ existing loans are likely to pick up.

This means their balance sheets – and capital ratios – might be less healthy.

As a result, implementing negative policy rates might be less effective in providing stimulus to the economy.

  1. Fight deflation but this creates problems for savers
    In economic downturns people typically hold onto their money and wait to see an improvement before they ramp up spending again. As a result, deflation can become entrenched in the economy.

People stop spending, demand declines, prices for goods and services fall, and people wait for even lower prices before spending.

Negative rates fight deflation by making it more costly to hold onto money, incentivising spending.

Theoretically, negative interest rates would make it less appealing to keep cash in the bank.

But the big problem is instead of earning interest on savings, depositors could be charged a holding fee by the bank.

This is a particular issue in the UK where so much money is held in building societies like Nationwide.

The worry is that savers will take their money out of the banks and put it under the bed.

While there are some costs and difficulties with holding cash, such as storage costs and the practicalities of paying bills and receiving wages, the incentive to use it as an alternative to a deposit account is likely to increase if interest rates fall below zero.

Of course not all banks will pass on the negative rate to consumers but this can be difficult for some small banks and building societies.