During this crisis countries have had to resort to a wide range of extreme methods to either maintain the economy or prevent mass unemployment. What would traditionally be considered unconventional monetary and fiscal tools has now become accepted as normal, despite being unprecedented for some.
Economic policies are divided into two groups: monetary, involving interest rates and base money supply by central banks; and fiscal, the tax and spending of governments. We have seen governments around the world be extreme with fiscal policy with money handouts to businesses and individuals, and furlough schemes where governments having been paying the wages of millions of employees.
Central banks too have expanded their balance sheets by starting or expanding asset purchase programs to either fuel fiscal policies or support financial institutions. Effectively, expanding base money supply in order to stimulate or prop up public and private entities.
What are negative interest rates?
By “interest rates” we are referring to the Bank of England (BoE) base rate. This is the interest rate that the BoE applies to excess money that commercial banks deposit with it. The base rate is also used in financial produces such as loans where the interest rate would be, for example, the base rate plus 3%. Additionally, the base rate influences the interest rates that banks apply to savings accounts.
When the BoE wants to reduce spending in the economy it will raise the base rate making credit (loans) more expensive. But to increase spending in the economy the BoE will lower the base rate making credit cheaper. This is used to both stimulate or reduce economic activity and control inflation.
In March the BoE cut the base rate to 0.1% to encourage people to spend more and save less and therefore stimulate economic activity. In theory, should the base rate go negative in theory this would encourage more spending and less saving.
Why would the interest rates turn negative?
The primary role of the Bank of England is to control the rate of inflation, its target is 2% per year. This is considered to be a stable level where prices and wages can increase in a controlled way. If inflation is too high the cost of living could quickly outpace peoples wages but if inflation turns negative (deflation) people will not want to spend money hurting business.
In March the inflation rate as measured by the Consumer Prices Index (CPI) stood at 1.5%, in April that fell to 0.8%. While the causes of this reduction of inflation is relatively obvious, how to boost economic activity is a difficult task; especially when interest rates are already at all time lows.
Therefore, the BoE has two options: inflate the money supply by creating new money and purchasing assets such as bonds to reduce pressure on companies and encourage more growth; or lower interest rates below zero so that companies, banks and savers face paying to hold on to their money resulting in increased economic activity.
What have other countries done?
Sweden, Switzerland, Denmark, Japan and the Eurozone have all had negative interest rates, the lowest being Switzerland at -0.75%.
Since the 2008 financial crisis savers have had very poor returns on their deposits as interest rates have been very low. In a negative interest rate scenario savers would be further penalized. While negative interest rates could in theory be applied to savings accounts, it would be more realistic to expect that savers with large deposits be hit by a negative interest rates, while small deposits have a zero rate.
In Germany some banks have charged interest on deposits over €100,000, and Switzerland on deposits of over 2 million Francs.
In countries that have experienced negative interest rates people have typically moved their money to either higher return assets such as stocks and bonds, save haven assets such as silver or gold, or into cash.
Having negative interest rates has yielded mixed results. If people move their money from savings to the stock market, this could stimulate markets giving higher returns. But if people simply move savings to cash or other non-spending assets then the BoE will not achieve their desired results of a stimulated economy.
In August 2019 Jaske bank, the third largest bank in Denmark, offered a negative interest rate mortgage for the first time paying borrowers 0.5% annually. It also offered a 0% rate on 20 year fixed rate and 0.5% on 30 year fixed rate. Such negative interest rate mortgages could stimulate the economy by increasing the housing market and sectors of the economy that are related. But you would need to be weary of when interest rates go back above 0.
Could negative interest rates happen in the UK?
There was a lot of speculation in the last week that the Bank of England could move the base rate below zero. However, at this time it is pure speculation. The BoE is still in the process of understanding the impacts of negative rates.
Last week while talking to MPs the BoE governor Andrew Bailey stated that it would be irresponsible to rule out any monetary policy action. It is possible that the UK could follow many other countries to negative rate territory, but such an action would most likely be short term.