Negative interest rates: what are they and are they on the horizon?

As a second national lockdown gets underway, along with fears of a double dip recession, the debate around negative interest rates is likely to resurface. With Mr Sunak extending the furlough scheme until March next year, all eyes will now be on the Bank of England over the coming months to see how far monetary policy can stimulate the economy.

In its November Monetary Policy meeting, the Bank of England voted to hold interest rates at 0.1% and increased its bond buying programme by a further £150bn. To date, the Bank has increased its firepower by around £460 billion to fight the effects of the pandemic, significantly more than during the Global Financial Crisis. But the Bank left one key question unanswered - under what circumstances could negative interest rates be utilised?

The Bank of England has been reviewing the appropriateness of using negative interest rates as a policy tool since the start of the pandemic. Last month, it exchanged letters with all UK banks and building societies to ask about the operational challenges that may emerge with a zero or negative Bank rate. But in a recent speech, Dave Ramsden, the Bank’s Deputy Governor for Markets and Banking, made it clear that this exercise was just part of their ongoing assessment.

The Bank is right to be cautious. Negative rates create problems - in particular for the banking sector - which need to be weighed against their ability to stimulate the economy. The objective of negative interest rates, as with conventional cuts in interest rates, is to stimulate demand in the economy; spending now is more attractive than saving. But compared with conventional interest rate cuts, two key questions need to be assessed.

Will negative interest rates actually be effective in stimulating the economy? Negative rates would see commercial banks charged to hold balances at the central bank, instead of receiving interest. To recoup this cost, banks could in theory pass this cost onto savers. In reality, banks will be reluctant to do this; disincentivising saving deposits would reduce the funds available for bank activity. Indeed, the experience of negative rates in other countries has seen banks choose to increase bank fees and charges instead. This means the pass-through and stimulating effect will be much weaker compared to a normal rate cut.

To what extent will negative interest rates create challenges for the banking sector? With banks unlikely to pass on charges for holding balances at the central bank, they will see a squeeze in their profit margin. And with banks already facing credit losses from the economic fallout of COVID-19, undermining profitability further could lead to problems with their ability to support the economy. And back to the first question - squeezed profits constrains lending capacity, which is counterproductive to stimulating spending and business activity.

The effectiveness of such a policy also depends on country-specific macroeconomic circumstances, structural features and financial systems. Indeed, the experience of negative interest rates around the world has been mixed. In Japan, negative interest rates have failed to stimulate an economy where ageing populations continue to save. In Sweden, the combination of five years of negative interest and a housing shortage led to a housing price bubble. In the Eurozone, the evidence is mixed; it suggests that overall negative rates have been effective at stimulating the economy and raising inflation, although the impact on the banking sector has varied by country.

Negative rates can be designed in various ways to try and limit the pressure it causes for banks - for example, tiering of reserves, whereby only some of the reserve balances they hold at the central bank are charged negative rates. As part of their ongoing review, the Bank will need to assess the risks and how they could be mitigated very carefully, before introducing any such policy.