Division at Threadneedle Street
During the last ten months, we have continuously highlighted the extraordinary policies implemented by central banks worldwide. They are at the forefront of fighting against the negative economic consequences of COVID-19.
Central bankers unleashed gargantuan levels of stimulus at the onset of the virus, to restore calm to markets by injecting liquidity, and facilitate economic growth. In the UK the Bank of England cut interest rates to their lowest ever level of 0.1%
Attention has shifted to ensuring the UK economy bounces back, and that it does so as quickly as possible. The BoE is reviewing existing its monetary policy framework and assumptions to aid the UK’s economic recovery. One area under review is the feasibility of negative interest rates.
We have written on this matter because it keeps cropping up in discussions amongst Bank of England officials. We decided to revisit the topic after considering a speech given by one of the Monetary Policy Committee (MPC) members, Silvana Tenreyro.
We look at the content of her speech and the reaction of other officials at the BoE, who appear less convinced about the merits of such a policy.
Negative Rates Explained
Tenreyro set out a considered argument for the virtues of negative rates. She suggested cutting rates from their present level of 0.1% to boost UK economic growth and generate a sustainable inflation; a policy goal that has evaded monetary policy authorities for almost a decade
How would it work? Well, the idea is by taking the Bank key lending rate even lower:
- the rates at which businesses and consumers can borrow would fall;
- savers are more willing to deploy cash by consuming or investing; and
- corporates will attempt to avoid negative rates on cash balances by investing or expanding.
It is important to note that the mere act of taking rates into negative territory does not necessarily translate to negative charges on loans for businesses and households. As highlighted in the speech, at present, the average rate on loans charged to UK households is 2.6%; significantly higher than the Bank Rate of 0.1%.
However, the overall net effect of reducing rates is to encourage borrowing and spending, boost aggregate demand and the UK’s recovery from the COVID recession, which, according to Tenreyro, faces three fundamental headwinds:
- local flare-ups in the virus;
- rising unemployment; and
- weak global economic backdrop
Evidence Supporting Negative Rate
The speech drew upon the experiences of other economies that have decided to introduce negative rates. The graph below displays the policy rates over time of those economies raising negative interest rates; Sweden, Japan, and the Euro Area. We have included the UK’s policy rate for reference.
Graph: Policy rates of several advanced economies.
Source: Bloomberg, data as of 31.12.2020
According to Tenreyro, central bankers should utilise negative rates according to the specific economy’s conditions in question. Commentators often cite the Japanese experience to question the efficacy of a negative rates policy. From the chart, you can see that they have operated under an ultra-low rate regime for a long time, but without managing to stimulate much growth and very little evidence of inflation currently at 0.3%.
Tenreyo points out that the efficacy of a negative interest policy is determined by the openness of an economy, its size, and household debt levels. Japan doesn’t fit this profile. Yes, it is large, but it is also a relatively less open economy. Additionally, its citizens have a tradition for saving rather than consumption, mainly due to its ageing population.
What Can We Infer About the Policy for the UK?
In the speech, Tenreyro concedes that making precise predictions are difficult. However, she believes the UK economy could positively respond to a negative interest rate policy and help generate inflation due to its economic profile.
When interest rates fall, an economy’s currency also drops relative to others. The fall in currency has the effect of making an economy’s exports more attractive, while pushing up the price of imports and driving inflation. For open economies with a negative trade balance such as the UK, reducing rates into negative territory could prove more inflationary than those that are historically more closed.
Likewise, the UK economy has higher household debt levels than other economies due to higher homeownership rates. Therefore, taking rates into negative territory will have a more significant, more positive impact on the household’s purchasing power and the UK economy.
An Opposing View -Bailey’s Scepticism
Considering the above, does that mean we are likely to see negative rates introduced in the UK?
Comments made by the Governor of the Bank of England, Andrew Bailey, after Tenreyro’s speech, highlight splits among its key decision-makers.
When asked his view, he responded by stating ‘there were lots of issues’ with reducing the UK’s interest rate below 0%. Bailey scepticism stems from a desire to avoid reducing bank lending levels, the exact opposite of the policy’s desired outcome. His rationale against negative rates is as follows:
- banks’ ability to make a profit on deposits would fall;
- banks will therefore become less willing to make loans to businesses and households;
- credit conditions in the UK would tighten; and
- UK GDP would fall.
If proponents of negative rates are to win the argument, they face tall hurdles to seeing the UK’s policy. Opinions amongst key policymakers remain divided.
Other tools are available if the BoE wishes to ease monetary conditions, such as purchasing corporate credit, which may yet prove necessary if politicians extend lockdowns.
The BoE’s most influential decision-makers are taking great care to navigate the next leg of the UK’s economic journey by testing their thoughts in a public manner. By doing so, they are inviting comment.