Not Interested: Bank of England shows considerable interest in negative interest

June 16, 2020

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3 min read

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What's going on here?

To counteract an expected economic contraction of 25% in Q2, the Bank of England (BoE) is considering an unprecedented move to take its base rate into negative territory to incentivise lending and thus stimulate the UK economy.

What does this mean?

The BoE’s base rate determines the amount of interest it pays to commercial banks storing money with it, which in turn greatly influences the interest banks charge borrowers and pay to saving customers.

Lowering the base rate is a form of economic stimulus which encourages banks to make loans during periods when they would rather keep hold of funds. With cheap loans, households are more likely to buy products; and with low savings interest, businesses are more likely to invest money rather than saving it in a bank. 

With pressure mounting on the BoE as COVID-19’s impact reverberates across the economy causing the inflation rate to fall to 0.8% (far below the 2% target), emergency measures will have to be taken. But the central bank will need to weigh the overarching objective to stimulate the UK’s economy against the various downsides of a negative interest rate.

What's the big picture effect?

One way banks make money is by paying less to savers than they make with lending, but lowering the base rate reduces banks’ net interest margin and thus squeezes their profitability. Although banks can lower interest rates to reflect the BoE’s lower base rate, mitigating a negative base rate is challenging, as charging customers interest on savings could cause a bank run (when customers rush to withdraw money from the bank leaving the bank without any money). 

One option is for banks to pass losses onto big companies, which is how many Swiss and German banks have operated since being subjected to the Eurozone’s negative base rate introduced in 2014. This hasn’t, however, prevented the banking sector from losing  €25bn (£22bn), according to banking executives. The European Central Bank claims bank lending has increased 0.7% per year since 2014, but various economists have warned of corrosive long-term side-effects of a negative base rate. This includes the country’s currency being weakened. Which means assets valued in sterling would yield less of a return against other countries’ currencies, thus cheapening the UK’s exports.  

Some experts believe buying bonds – which also lowers borrowing costs and spurs lending – to be more viable. This is a form of quantitative easing whereby the BoE creates new (digital) money to buy government debt. In March, the BoE announced its intention to buy £200bn worth of mostly government bonds on the secondary market. This has historically helped stabilise the financial markets (for example in the fallout of the financial crisis and the EU referendum) and would provide funding to the government’s COVID-19 financial support schemes.

With the BoE’s governor Andrew Bailey stating that negative interest rates are under “active review”, and the Debt Management Office recently issuing its first bond with a negative yield (minus 0.003%), it would be fair to assume a negative base rate is on the horizon. But with numerous experts and global banks pushing back and presenting good evidence for doing so, it’s likely that this nuclear option will only be introduced if the economy and inflation levels do not show signs of improvement.

Report written by Keir Galloway Throssell

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