The UK is looking for ways to set itself apart from its European neighbors after Brexit. On monetary policy, however, Britain could soon become more European. The Bank of England is studying the possibility of cutting interest rates below zero, as central banks in Denmark, Sweden, Switzerland, and the eurozone have all done in the recent past.
Policymakers should embrace the idea with enthusiasm. As Silvana Tenreyro, a member of the bank’s rate-setting Monetary Policy Committee, said in a speech on Monday, the international evidence shows negative rates are a helpful tool to boost growth and lift inflation. The criticism that they cause more harm than good appears vastly overblown.
The Bank of England is undergoing preparatory work to understand whether it would be feasible to cut the bank rate from its current level of 0.1% into negative territory. With the U.K. economy in a deep recession and inflation well below the bank’s 2% objective, it’s only natural to look for new things to try. But policymakers are divided, with the MPC’s internal members the most resistant to taking this controversial step.
The intellectual battle around negative rates goes as follows. Their supporters believe charging lenders for the money parked with the central bank will prompt them to extend more credit. Negative rates also discourage investors from holding their money in one's domestic currency, causing it to depreciate, which in turn can boost exports and make imports more expensive. Finally, if banks pass some of the extra costs on to savers, they will spend or invest more to avoid keeping money on their bank accounts, which in turn will help the recovery.
The critics, including several Wall Street executives, retort that taking rates below zero induces excessive risk-taking by investors who search for yield in ever more exotic realms of the financial sector. As far as the banks themselves, sub-zero rates are seen as too painful for profitability, leading them to cut back on lending to shield margins. Finally, naysayers argue, negative rates can actually push consumers to save more as they fear for the risk of ever higher fees on their deposits, which can become a drag on economic growth.
The Bank of England’s policy-setters have one big advantage as they weigh these opposing arguments: They can benefit from the hindsight of other countries that have already made the leap into negative territory.
The UK has a number of peculiarities to take into account. It’s smaller than the eurozone (though not compared to Denmark, Sweden, or Switzerland) and its companies borrow more from the financial markets. Households tend to have more debt, and a larger share of variable-rate or short-term fixed-rate mortgages. Finally the largest UK banks fund more of their household lending from household deposits. Still, one can look at the experiences on the continent and adapt the findings accordingly.
What Tenreyro found is on the whole encouraging for supporters of negative rates: Going sub-zero leads to an effective transmission of monetary policy decisions both through the financial markets and in the banking system. There’s little evidence of a negative effect on bank profitability, even though lenders don’t appear to pass extra costs on to consumers via negative deposit rates. Where they do — such as with companies — the end result appears to be to stimulate spending and investment. “Taking these points together, the evidence suggests that negative rates can provide significant stimulus,” Tenreyro argues.
The study comes with some limitations. For example, much of the evidence is from work by researchers at the central banks themselves. It’s possible they suffered from some element of confirmation bias, as appears to have been the case with quantitative easing. However, the independent studies cited appear to show very similar results.
Moreover, it’s hard to disentangle the exact effect of negative rates from other monetary policy tools deployed at the same time in a context of sharply deteriorating inflation and growth. Yet, Tenreyro points to the experience of Denmark, which cut rates below zero “only” to defend the peg between the krone and the euro: Here too, the experiment provided a stimulus to the economy (though less than elsewhere).
What about the UK’s peculiarities? They may not matter of that much, Tenreyro argues. In fact, they might even strengthen the argument for negative rates. For example, the higher level of indebtedness and the prevalence of floating-rate mortgages may mean their introduction could have a more immediate impact on consumers. Similarly, since the U.K. is a small, open economy, the impact of sub-zero rates on the currency could be more powerful than in the eurozone, and actually be an effective way to bring inflation back to the BOE’s target.
Negative rates will not solve the UK’s economic crisis, which is the consequence of the Covid-19 pandemic above all else. However, to the extent that the Bank of England can help, policymakers should use all the useful tools that are potentially at their disposal, including sub-zero rates. After taking a step away from rest of Europe, it’s time to be pragmatic and copy an effective page from its playbook.
(Bloomberg)
