Forget negative rates, it’s time to start listening to the economists

Taking rates below zero and pumping more QE into the economy will do more harm than good - especially if lockdowns persist

Negative rates

Last week we saw the policy authorities reaffirming the three key planks of current macroeconomic policy: no imposition of negative interest rates for now; more bond buying (ie money creation) by the Bank of England and an extension of the furlough scheme, which implies even more government borrowing.

Rather like the largely unchallenged thinking behind the adoption of a second lockdown, this combination of policies has not been subjected to due scrutiny. To avoid similar mistakes, the macroeconomic policy response to the virus should also be subject to open and frequent challenge.

Let us start with interest rates. Although the Bank has so far avoided taking interest rates negative, it has asked the banks to think about this and rates could go negative next year. Would this be a good thing?

Even during the best of times, interest rates are a blunt weapon. In theory, lower rates should encourage consumers to spend more now, both by making borrowing cheaper and by reducing the reward to saving. Similarly, they should theoretically encourage companies to invest more.

But these channels are extremely leaky.

In practice, such decisions are dominated by other factors – especially by views about the future. Interest rate changes also redistribute income between borrowers and savers and often their effectiveness will depend upon the different responses of these two groups.

These income changes can either support the incentive effect or overwhelm it. In current circumstances, they could easily overwhelm it, not least because hard-pressed savers may react by spending less.

Moreover, negative interest rates would tend to be reflected in lower government bond yields, which would exacerbate the problems facing pension funds, whose liabilities are calculated by discounting them at an interest rate dictated by the yield on government bonds.

Lower rates could thereby drive many pension funds into deficit, obliging their sponsoring companies to inject more money, thereby siphoning off funds which could have been used for investment. Accordingly, a policy which is supposed to boost aggregate demand could in fact have exactly the opposite effect.

Additionally, negative rates risk reducing the profitability of banks, thereby inhibiting them from lending more. And they would incentivise the hoarding of cash, which would be both inefficient and dangerous.

Moreover, they would represent a further development of the Alice in Wonderland character of the current monetary situation, with an increase in financial distortions which could carry significant costs later.

For example, much of the housing market is currently in the throes of a ridiculous boomlet. Admittedly, this is largely down to the Stamp Duty holiday, but a reduction of official interest rates into negative territory would simply be throwing more fuel onto the fire.

It is true that negative rates have been employed in a number of countries including Japan, Denmark, Switzerland, Sweden and the eurozone, apparently without deleterious effects. But neither has there been a positive transformation. And it is noteworthy that Sweden has already turned back from negative rates.

The second plank of current policy, namely Quantitative Easing (QE) seemingly extended without end, also needs to be carefully scrutinised.

It serves to keep down the costs of government borrowing but, other than that, I doubt that it does much good.

Moreover, precisely because it obscures the long-term costs of government borrowing it removes what might otherwise be an influence on Covid policy-makers. Might it be a different story if the Treasury was forced to find more private sector holders for its gargantuan issuance of new gilts?

It is often argued that when interest rates are as low as they currently are, governments should issue large amounts of long maturity debt, in order to lock in these low interest rates.

This view is essentially sound. But it conflicts with the policy of the Bank buying in debt. The Treasury can issue debt of whatever maturity it likes but if this debt is bought by the Bank then it hasn’t locked in the current low cost of finance. The debt purchased by the Bank has effectively been suspended.

The way to try to square this circle is for the Treasury to issue very long debt while the Bank buys in only debt of short maturities. Of course, even this would have an immediate cost because it would raise the yields on long debt.

True, some radical monetary thinkers say that all such debt held by the Bank could and should be written off. It could be. Yet, apart from playing havoc with the Bank’s balance sheet, this would be largely irrelevant.

The principle macroeconomic threat from all this borrowing will arise when the Bank has to reabsorb the excess liquidity that it has created. It will then have to sell some financial instruments to the private sector. But at what cost?

This brings us to the third plank. For all the future difficulties created by much increased government borrowing, in the current circumstances this is the lesser of evils. Even that former bastion of fiscal orthodoxy, the IMF, has come out in favour of governments being prepared to give much more fiscal support.

But no one should imagine that this comes without costs and risks. And all macroeconomic policy is currently of limited effectiveness.

The only thing that can really have a major effect in both boosting the economy, reducing financial strains and heading off a future fiscal calamity is a different policy with regard to locking down the economy.

Sadly, as we have again seen recently, the influence of economic considerations in the key decisions taken with regard to controlling the virus is next to zero.

Coincidentally, the standards of statistical analysis and forecasting technique employed by those senior medical professionals supporting a complete lockdown would not pass muster on the most basic economics course.

I realise that economics and economists have a low public standing but surely there needs to be a major input from economists into Covid decision-making – and not just about the economics.


Roger Bootle is chairman of Capital Economics
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