The historic coronavirus shock has triggered a fresh assessment by Bank of England policymakers about the suitability of negative interest rates in the UK.
Under its two previous governors Lord Mervyn King and Mark Carney, the Bank stayed well away from such a move, even as other major central banks, including the European Central Bank and the Bank of Japan, undertook their own experiments with policy rates below zero.
But the Old Lady of Threadneedle Street has changed her tune since Andrew Bailey took over as governor in March. In the middle of the global coronavirus panic in spring, he advanced the idea by emphasising that policymakers were considering all options in response to the crisis.
The Bank Rate is at a historic low of 0.1pc. In practice the Bank can set this rate, which it pays on overnight deposits held at the bank, at any level it wants. In the case of a negative bank rate, the Bank would charge lenders on the liquidity they park at the bank.
Such a move does not look imminent, though. The Bank is working with banks and other credit institutions to prepare the relevant operational and technical details so that policymakers could have the option of lowering the bank rate below zero at some future date.
It thus begs the question: could conditions soon justify the Bank cutting the bank rate below zero? Three reasons suggest the answer is no.
Credit where it’s due
First, monetary policy is working well. Through a combination of conventional and unconventional tools, the Bank is supporting a steady flow of credit, keeping inflation expectations anchored slightly above the 2pc target and holding benchmark rates at ultra-low levels.
Despite the uncertainties linked to coronavirus and the UK’s upcoming exit from the EU single market, lenders are not rationing credit. UK banks have strong-enough capital and liquidity positions to transmit, rather than counteract, the Bank’s expansionary policies.
Helped by the Government’s generous credit guarantees, households and firms facing temporary cash constraints are largely able to obtain loans on generous terms.
Second, a negative bank rate could introduce costs and risks that could harm parts of the UK economy and its financial system. Negative rates reduce banking-sector profitability and lower incentives for long-term saving.
In an extreme scenario, such costs may constrain a future recovery by damaging confidence, thereby inadvertently giving rise to the sluggish recovery from the coronavirus shock which the Bank hopes to avoid.
Lots of ammo
Third, policymakers still have plenty of firepower left in their existing toolkit. The Bank has the power to create de facto unlimited bank reserves as it sees fit – subject to its price and financial stability mandate – to supply loanable funds to the banking sector.
The only really relevant question is whether or not there are enough assets available for the Bank to buy with any newly created fiat.
From its several rounds of QE (quantitative easing), which started in 2009, the Bank has bought about £690bn in government debt (gilts) on the secondary market. Following Thursday's announcement, it plans to buy a total of £875bn government bonds by the end of next year.
The UK Debt Management Office estimates that the market value of gilts was £2.6 trillion in the second quarter. Given the astonishing rate at which the Government is issuing debt to finance its pandemic policies, at an average of £26bn (net redemptions) between April and September, the total stock of gilts available for purchase continues to rise.
Although the Bank may need to eventually change its self-imposed rules that limit the proportion of eligible government bonds it could buy, the risk that it could soon run out of such paper to buy looks vanishingly small.
Other inflation-targeting central banks that have used negative rates have faced at least one of two serious problems: collapsing inflation expectations or severe banking sector weaknesses that impaired the transmission of monetary policy. Fortunately, the Bank faces neither of these challenges.
Nevertheless, for as long as short-term interest rates are low, the risk that the UK could fall into a liquidity trap that could render current monetary tools ineffective hangs over the heads of policymakers.
What else is in the toolbox?
Hence, it remains prudent for the Bank to broaden its toolkit as much as possible in case of a future emergency.
With this in mind, the Bank should also consider the other options available. With the aim of avoiding some of the drawbacks of negative rates, two alternative policies could work well.
One option is for the Bank to target long-term benchmark rates in a pre-determined way using its standard QE operations until certain conditions are met (say until real GDP exceeds the pre-pandemic level or unemployment falls below a certain rate).
Such “state-dependent yield curve control” has the advantage of targeting the benchmark bond yields that are used to price credit, rather than merely influencing them via reducing the bank rate even further or normal QE.
Alternatively, the Bank could enhance its targeted credit policies. These include the Term Funding Scheme, which the Bank rolled out after the Brexit vote in 2016 and expanded with additional incentives for lending to SMEs after the pandemic.
There is no reason why the Bank could not use such targeted tools to provide loanable funds to lenders at negative rates.
Of course, all policies come with drawbacks. Yield curve control could be viewed as verging too far into the territory of fiscal policy, while targeted measures may not have a broad enough impact on credit markets. But unusual times require unusual measures.
Too often, the case against negative rates or other unconventional policies stems from an unease about central banks straying beyond their normal terrain. This is misguided.
It comes down to the question of what is the right tool for the job at the time. Of course, no one can say what the future holds, but for now, the balance of arguments does not favour negative rates for the UK.