Bank of England rates have once again remained unchanged
Current Affairs

Will we live in a country of negative interest rates?

And so, the purgatory-like inertia that is the Bank of England rate remained unchanged at 0.5 per cent for the 87th consecutive month. Must be an exciting job that, being part of the Monetary Policy Committee.

All jokes aside, the relentless entrenchment of rates at this record low doesn’t become any more palatable for savers and investors as the sands of time roll on. A decade ago to the day, BoE rates were a comfortable 4.5 per cent, and in the latter half of 2007, they climbed to the dizzy heights of 5.75 per cent. Who on earth would have bet back then that we’d find ourselves in the position we’re in now? Probably the same sort of person who bet on Leicester City to win the Premier League!

When will the status quo change?

Again, this is almost anyone’s guess. There had been some optimism within the ranks of top economists in the latter half of last year that rates could increase at some point during 2016. However, a bumpy start to the year has put paid to such hopes, and unexpectedly poor growth of just 0.4 percent during the first quarter has sparked fresh fears of a downturn. Compounding this, the uncertainty surrounding the EU referendum, the closure of stores like BHS and the poor performance across various British industries such as steel and oil & gas has left investors predicting that rates won’t reach 0.75 per cent until at least 2019.

Instead, the more likely result is that in the near future we’ll be bracing ourselves for a cut to rates. So, how low can Governor Carney go? The bad news is that zero percent isn’t even the floor, with negative interest rates becoming a possibility at some point. We’re not sounding the panic alarm just yet, and any cuts – if they were to happen - would likely just be by 25 basis points for now. But it’s fair to say that negative rates in the UK aren’t as unthinkable as they once were.

Why would central banks adopt a negative rate?

Such a hanging spectre is actually a reality for central banks in many countries already – Japan, Switzerland, Denmark and the European Central Bank among them. What this means is that depositors are actually charged for keeping their money in the bank.

The reasons for adopting negative interest rates are varied. In the cases of Sweden (2010) and Denmark (2012), the reason for doing so was to stem the flow of hot money into their respective economies. Typically though, it is used as an attempt to reinvigorate an economy by encouraging borrowing (and thus spending) by consumers and companies alike.

Another example is the European Central Bank, which opted for negative interest rates on bank deposits (they charge banks 0.3 per cent to hold cash overnight); primarily to deter the threat of deflation, but also to devalue the euro in a bid to stimulate demand for exports. Low or negative yields would discourage foreign investors, and thus see demand for the euro dwindle. While it may sound counter-productive to reduce the flow of investment, Europe’s major issue is demand, not supply, and the theory was that by encouraging exports – not to mention making borrowing more attractive – businesses within Europe would invest and expand.

Does it work in practice?

It certainly isn’t an unfounded school of thought but, make no mistake, adopting negative interest rates represents a desperate measure, and implies that all other options have been exhausted. Theory and practice, as with most things in economics, can often produce a discrepancy too. If, for example, banks did charge interest to depositors, it could result in a bank run as they look to store their cash under the mattress for free instead, which in turn would deny lenders the funding they need.

Yet if banks decide to waive such a negative charge of interest on deposits instead, they end up squeezing the profit margin between their lending and deposit rates; especially when you consider that things like mortgages are contractually tied to the interest rate. This may then result in banks becoming even less willing to lend, which would entirely defeat the original purpose of the exercise.

Aside from obvious pitfalls like these, experts believe that unintended consequences could result from negative interest rates as well. The major one being bandied about by economists is that of a currency devaluation war in the fight to boost exports, which could have disastrous effects across the globe.

So, where to from here?

Again, we must emphasise that there is no indication as yet that the Bank of England would go down this route anytime soon. However, it is something that will be giving Carney and Co plenty of food for thought, and they will be hoping that the various threats plaguing our economy – both internal and external - subside in the near future. Otherwise the MPC may well have some excruciating decisions to make before this decade is up.

Main image 'Bank of England' by George Rex. Image subject to copyright. A link to the image and appropriate licence can be found here. You must not use or reproduce this image other than in accordance with the licence.

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Michael Todt

Mike joined Lending Works in early 2015 with a background in marketing and journalism. Having long held a passion for economics, he is now the chief contributor to the Lending Works blog, and regularly writes about all things peer-to-peer lending, fintech and personal finance.