Is The UK Preparing For Negative Interest Rates

By Sofia Kaur

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Imagine paying the bank to hold your money?

In the modern world of today, we are incentivised to deposit money where we can earn the highest return, that is, those banks offering the highest interest rates on the array of different savings account posed to the consumer. If another bank is offering optimal savings rates, we switch. But what if the tables were turned and the consumer had to pay the bank a ‘return’ to save their money?

This has in fact been a reality for many European Countries in an attempt to accelerate recovery after the 2008 Global Financial Crisis. In July 2009, the Swedish Central Bank was the first central bank in the world to introduce negative interest rates at -0.25%, later followed by various other European Central Banks and the BOJ in 2016. This raises the question of whether negative interest rates will be deployed by Central Banks to combat the current (and most likely worse) recession as a result of Covid-19.

With the Monetary Policy Committee having already set record low interest rates at 0.1% and the UK Economy expected to shrink by 14% according to figures by the ONS, the UK will be facing its sharpest downturn since the 18th Century. The Governor of The Bank of England, Andrew Bailey, already stated in May that negative rates were under ‘active review’. Thus, with such a possibility potentially looming, how do negative interest rates work?

Retail Bank’s set their lending rate to consumers based on The Bank of England’s interest rate, also known as the policy rate. An inflation-targeting Central Bank set the policy rate so in turn, the economy reaches the inflation target, 2% in the case of the UK. Therefore, the rate set by The Bank of England and that is publicly announced is not the lending rate facing the private sector, although it is indicative. The interest rate set by retail banks is broadly equal to their marginal cost of lending (policy rate) plus a margin to compensate for risk. Hence, one may assume that negative interest rates will also be passed onto the private sector.

The logic behind cutting interest rates below 0 is to stimulate economic growth, hence the applicability of such a tool in a recession. This will happen through a number of different mechanisms. Both consumption and investment by consumers and firms will be encouraged as the cost of borrowing money will fall and holding savings in the bank will be costly. Theoretically, this should increase the country’s GDP as both consumption and investment are components of economic growth. That being said, there is evidence arguing that increasing credit in an economy does not increase economic growth.

With lockdown measures being eased and the economy slowly opening up it is uncertain whether the MPC will need to introduce negative interest rates. However, being a rare tool used in practice and talk of ‘the recession to end all recessions’ understanding the concept provides some food for thought.

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Key Takeaways

• The UK could undertake negative interest rates

• It could hypothetically improve the UK economy

• It has had mixed results in other countries who have implemented negative interest rates