After the UK has faced arguable one of its worst recessions, the BoE has refused to rule out the use of negative interest rates to help stimulate demand back into the economy. The base rate has already been slashed to its lowest ever at 0.1% to help deal with the expected 14% fall in GDP. Have the banks lost rationality or is this an ingenious cure for Covid-19’s impact on the UK economy?
Patient Zero of the negative rate was Sweden, with the Riksbank setting its rate to -0.25% in an attempt to lessen the impact of the financial crisis. The European Central Bank and Japan have since adopted negative rates, both for the same reason, to stop the prospect of a deflationary spiral. As the converse to the positive rates, negative rates serve to punish banks and consumers alike for hoarding cash in an attempt to stop economic agents deferring their spending, the key cause of the deflationary spiral. For consumers who wish to save money in a bank therefore, it is likely they will have to pay a storage fee, a much greater disincentive than a low interest rate.
On the other hand, the bank must pay you for taking out a loan, which aims to encourage economic agents to once again invest or purchase big ticket items and hence stimulate demand. Negative rates mean the sum of repayments will total less than the loan given and so in real terms the bank pays you.
Negative interest rates, may not be as effective in practice however. One significant threat is alternative saving, i.e. consumer storing cash in their homes, which could lead to a run on the bank but is more likely to create a long-term capital sink from the banking system. Said sink could force banks to begin raising interest rates to increase revenue and hence negate the whole purpose of negative rates.
As the UK economy aims to recover from Covid's economic blow, it may be forced to look at this exceptional action. Although the jury is out on whether negative interest rates can be the saviour, the BoE will have courageously break the 0% lending floor. Only time will tell whether negative rates are beneficial or even are used but it is worth considering whether this negative rate cycle is worth the short-term boost to aggregate demand.
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