Forget negative rates – the Bank of England should admit it's hit rock bottom

A more hawkish sound from major central banks could, contrary to conventional theory, encourage a modest revival of inflation

The fact that the Bank of England is asking banks about their preparedness for negative interest rates is very disturbing. Keeping interest rates very low is damaging enough; reducing rates to less than zero would be even worse.

Low interest rates are supposed to encourage productive investment by business and increase consumer spending, thus providing a boost to the economy. When the Bank of England cut rates in response to the financial crisis of 2008 this was the right policy, and it worked. The risk of recession, very real at the time, was controlled. But the continuation of ultra-low interest rates for year after year has started to do more harm than good.

The theoretical appeal of negative rates sounds plausible: the idea is that if you put your money on deposit and then later get back less than you put in, you will be incentivised to spend earlier rather than later so as to avoid the penalty of keeping the money on deposit. So, yes, negative rates do discourage you from delaying spending that you were planning to make.

However, this is not the end of the story. Negative or ultra-low interest rates can be economically damaging. There are several reasons why.

First, the policy sends a clear warning the central bank thinks there’s trouble ahead. This results in people not spending but saving their money in preparation for the coming storm. The policy therefore deters not only retail spending but also commercial investment, since business investment depends on individual consumption, albeit indirectly in some cases. An industrial manager is not going to invest in a plant to double production unless they believe there is a reasonable chance of increased sales in the future.

Second, as interest rates decline, companies with defined benefit pension schemes, and there are still thousands of them, need to put more money into their pension funds to pay out the promised level of retirement incomes. This leaves less money left over for investment in the business and for dividends to shareholders.

Third, the less interest deposits yield, the more an individual needs to save in order to sustain a given income. In a low interest rate environment, everyone draws in their horns. Negative rates are likely to be even worse. These factors all tend to slow economic activity.

Little or no inflation also acts as a brake on the economic recovery. People tend to postpone spending if they are not worried about prices rising. Indeed, the rise of online shopping has led to acute competition that has resulted in the prices of some goods falling.

Low interest rates increase the value of capital assets like property or shares. The equity markets have indeed produced good returns since interest rates were slashed over a decade ago. Unfortunately this has widened the gulf between the “haves” and “have nots”.

The one group that does benefit from low interest rates is borrowers. Since our Government is now borrowing on a larger scale than ever before, it is fortunate that the interest it has to pay is less by an order of magnitude than would otherwise have been the case.

It is time for the central banks of the US, Canada, Japan and the EU, as well as the Bank of England, which are all supposed to be independent of their respective governments, to send a signal that the next interest rates move will be towards a gradual increase. (Co-ordination is needed to avoid a risk of disruptive competitive devaluation.)

This signal would reverse the trends outlined above, and may also, contrary to conventional theory, encourage a modest revival of inflation. This itself would be welcome as inflation is the best way of reducing national debts.

Another benefit of modest increases in interest rates would be to make banking more profitable. This is necessary. Profitable banks are more secure and increasingly likely to lend money to those businesses that need it.

A vicious cycle could be turned into a virtuous one.

Sir Martin Jacomb, is a former vice-chairman Kleinwort Benson and former deputy chairman of Barclays