In their Financial Times article, Richard Milne and Martin Arnold described negative interest rates as ‘’the biggest monetary policy experiment of modern times. One that has divided economists, central bankers, and governments’’. On 14 December 2020, Reuters published an article in which major UK banks raised their concerns about introducing negative interest rates (<0) in the United Kingdom. The current Bank Rate is 0.1%.
According to the Bank of England, Bank Rate is the most important interest rate in the UK. In the press, it is often called ‘the Bank of England base rate’ or even just the interest rate.’ Bank Rate is set by the Monetary Policy Committee aimed to keep inflation low and stable. In generic terms, interest rates determine how much households and businesses pay to borrow money or get paid by banks to deposit money. So if you decide to open a new saving account and deposit £100 today with an interest rate of 0.15%, you should have £115 after one year. However, Bank Rate is not the only factor that may affect the actual interest rates set out by commercial banks. Bank of England (BoE) explains why interest rates can change for other reasons:
''Interest rates can change for other reasons and may not change by the same amount as the change in Bank Rate. To cover their costs, banks need to pay less on saving than they make on lending. But they can’t pay less than 0% on savings or people might not deposit any money with them.This means that when Bank Rate comes close to 0%, how far banks pass it on to lower saving and borrowing rates reduces. And as Bank Rate starts to rise away from close to 0%, that’s likely to lead to less of a rise in saving and borrowing rates.''
In an ideal world, which we people are not clearly a part of, the government and its citizens would like to see the economy grow constantly and sustainably with rates of inflation rising steadily, low unemployment levels, and thriving communities. When such growth becomes unsustainable, and the economy expands too quickly, causing large rates of inflation not supported by a parallel increase in wages and labour conditions, central banks would generally increase interest rates to stimulate this growth and prevent inflation from reaching unsustainable levels that could seriously damage the economy in the long-term. On the other hand, during a crisis and economic slowdown or recession, central banks tend to decrease the interest rates to make borrowings cheaper and encourage spending so that the economy has a basis to recover. During the financial crisis of 2007-2009, BoE had changed the Bank Rate from 5.75% in July 2007 to as low as 0.5% in March 2009. At the start of the outbreak of the Covid-19 pandemic in the UK, Bank Rate was decreased from 0.75% to 0.25% in March 2020 and then quickly dropped again to the current value of 0.1% (as of December 2020). The base rate of 0.75% that lasted till the beginning of March 2020 was the highest since February 2009 (1%).
What is it all about those negative rates? Commercial banks deposit their reserves with central banks, which would then charge interest on keeping such deposits if the interest rates were negative. This is aimed at encouraging commercial banks to spend and increase lending of their funds. In theory, negative rates also cause a situation where investors receive interest on borrowing. It seems a perfect scenario: a business or a commercial bank takes a loan, and as long as interest rates remain negative, they might end up paying back less than they borrowed. So why do this phenomena divide economists, bankers, and politicians?
First of all, negative interest rates reduce a bank's profitability in the long run. After the crisis of 2007-09, we all realised how important the well-being of financial institutions and markets are for our economies. Thus, negative interest rates may prove to be extremely risky for the long-term prosperity of banks. In such times, individuals are less interested in depositing money in saving accounts and prefer to hold on to a cash. In turn, this may affect banks' liquidity and ability to lend money as the savings accounts, and their deposits are partially funds that bank uses, e.g., to provide loans. In a video created by CNBC - How Do Negative Interest Rates Work?- experts have expressed their concerns about whether negative interest rates provided enough of an incentive for everyone to borrow and invest more money. This process of running an economy with negative rates has been flagged and considered a perilous policy that puts the financial system at stress. According to Jim Bianco, President and CEO at Bianco Research suggest that "it is the financial sector that banks, insurance companies, pensions… the security settlement are all structured and invented on one assumption – positive interest rates".
Other experts observed that negative interest rates introduced in other European countries, such as Switzerland, Denmark, or Germany, did not cause a rise in inflation, and the growth has not come back as strongly as some people had hoped. Nonetheless, central banks responsible for monetary policies in their countries must proactively develop strategies that will best mitigate the negative effect of the Covid-19 pandemic. It does not seem that we are currently trying to revitalise the economy, but rather keep it going for as long as possible.
Another important consideration is how interest rates affect bonds, especially those issued by the government or other financial instruments. A bond is a debt security that promises to make payments periodically for a specified period of time. Governments issue bonds so that they can increase their spending ability. So in normal circumstances, an investor would buy a bond, thus lend money to a government, while hoping for interests to accumulate over time. In generic terms, government bonds are considered a safe investment as governments of well-developed countries are reliable borrowers, rarely failing to pay back the principal amount. However, bonds are safe investments if rates are positive and above the current inflation level; otherwise, investors would find it difficult to make any money as it happens with bonds that have negative yields.
Without a doubt, we live in times where governments are not in an easy position to determine a country's monetary policy to benefit the economy at its best. Depending on how quickly we manage to fight off this pandemic, it will determine when we can return to our 'normal lives' and what tools can be used to revitalise our crippling economies. The concept of negative interest rates is contemporary, and its effects are not fully known. Nevertheless, it is something that many central banks have already done or considered doing. There is still much skepticism among economists, politicians, and bankers.
Bibliography
The Bank of England (n.d.) Interest Rates and Bank Rates. Available at https://www.bankofengland.co.uk/monetary-policy/the-interest-rate-bank-rate
CNBC (2020). CNBC Explains: How Do Negative Interest Rates Work? Available at https://www.youtube.com/results?search_query=negative+interest+rates
Milne, R., Arnold, M. (2020). Financial Times: Why Sweden Ditched its Negative Rate Experiment. Available at https://www.ft.com/content/478fe908-5168-11ea-8841-482eed0038b1
Jones, H., Withers, I. (2020). Reuters: Move to Negative Rates in UK May Not Work, HSBC warns. Available at https://uk.reuters.com/article/britain-banks-rates-idUKKBN28O2GQ
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