Comment

The Bank of England should not impose a negative interest rate

Forcing depositors to pay for the 'privilege' of lending is not the answer to this crisis

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Can we please stop talking about a negative Bank Rate; even another dollop of quantitative easing would be preferable to that.

The Bank of England, of course, denies that its letter to banks this week, asking whether they were ready for such a policy move, indicates that it is about to impose one. Definitely not, the Bank insists; it isn't even asking banks to ensure they are adequately prepared for one. The only intention is to ask about their state of preparedness.

Believe it if you will. The Bank of England does not send out a letter like that without full knowledge of the signal it sends to markets. And this one was loud and clear. With the economy again stalling, all options are back on the table, including taking the Bank Rate negative. A policy which up until now had been pretty much ruled out by Andrew Bailey, Governor of the Bank of England, is now firmly on the agenda.

Before taking the plunge, the Bank needs to ask itself the following questions – will it make any difference, what is the evidence for thinking it would have a positive impact, and might not the negative effects outweigh any positives? If the answer to these questions is no, debatable and very possibly, it shouldn’t be doing it.

This is what the Bank of England had to say about negative interest rates as recently as its August Monetary Policy Report: “Risks to banks’ balance sheets are likely to be rising at the moment. The impact of Covid-19 on the economy will result in losses for lenders, as some businesses fail and some households lose their jobs. As a result, implementing negative policy rates might be less effective in providing stimulus to the economy at the current juncture than at a time when banks’ balance sheets are improving.”

The purpose of any cut in official interest rates, whether into negative territory or simply a normal, common all-garden cut, is both to reduce the attractions of holding cash, driving savings into riskier assets, and to cut the cost of credit in a way that encourages banks to lend more to the economy.

Theoretically, there is no reason why the effects shouldn’t be just as potent when cutting into negative territory than with any normal interest rate cut when the rate is positive. Theoretically, both achieve the same outcome. Yet when the cause of the downturn is not the business cycle, but an enforced closure of large parts of the economy so as to ensure social distancing commensurate with a pandemic, you have to question whether it would have the normally expected effect.

Cheaper borrowing costs are unlikely to persuade firms to borrow more to stay afloat when their chief concern is not about the costs of the extra borrowing but how they are ever going to repay the money when there is no end in sight to the measures deemed necessary to contain the pandemic. Banks should not be forcing companies and households to borrow what can never be repaid.

The chief problem with cutting below the so-called “lower bound” is its effect on the profitability of banks. Broadly, banks make their money on the margin between deposit and lending rates. But in practice, it is difficult-to-impossible to charge retail depositors on their cash balances (wholesale money may be another matter), particularly in the UK, which largely operates on a “free” banking model, where the cost of administering accounts is paid for by the spread between lending and deposit rates.

With a negative rate of interest, you potentially have a situation where the debtor is paid to borrow while the creditor is charged to deposit. That’s a topsy turvy world, and if it badly impacts profitability, then perversely banks may end up lending less to the economy, not more.

The European Central Bank, which has been operating a negative discount rate since 2014, claims to have got around the problem by adopting a two-tier system through which a significant portion of excess reserves are exempt from negative rates. The ECB also provides a facility that allows banks to borrow from the central bank at highly favourable rates, provided they extend sufficient credit to the real economy.

But has any of this really helped? Naturally, the ECB claims it has; it has encouraged banks to provide more credit to the economy while through its mitigation strategies protecting the profitability of the banks.

Maybe, maybe not, but the eurozone economy has hardly been a rip-roaring success over the past six years. I've not seen any evidence to suggest the effect is anything other than marginal at best. Is it really worth entirely exploding the notion that debt carries a cost, and deposits some form of return, for such a questionable benefit?

With negative rates, you have the feeling that like governments, central banks are flailing around in their pandemic response. Just being seen to do something, even when ineffective, is the name of the game.

This is not a normal, cyclical demand-side recession, but a self-inflicted supply-side shock. The answer lies in getting to a position where the restrictions can be removed, not forcing depositors to pay for the “privilege” of lending their money. There is frankly not a lot more the Bank of England can do to help matters, other than keep on financing the deficit.