Negative Interest Rate Possibility Remains Alive in the UK In Face of Slow Economic Recovery

  • Aug 10, 2020 BST
  • Team Kalkine
Negative Interest Rate Possibility Remains Alive in the UK In Face of Slow Economic Recovery

Summary

  • BoE may contemplate a negative interest rate regimen to support the battered economy of the nation
  • The bank had explored the possibility of using negative interest rates in its quarterly monetary policy report published earlier this month
  • The bank had at the beginning of March increased lowered its interest rate to 0.1 per cent and expanded its asset repurchase programme to £1 trillion, to fight the coronavirus pandemic and the ensuing slowdown. 

In the face of the very slow state of recovery, the Bank of England (BoE) is now actively contemplating a negative interest rate regimen, about which it had referred to in its latest monetary policy report. The bank though does not see the immediate need to use this tool, though it remains a part of its toolbox. Negative interest rate virtually means that a borrower will pay back less to the bank at the time of maturity than what he borrowed and is an expansionary tool in the hands of a central bank. Though rarely, but the tool has been used in the past by the European Central Bank (ECB), Switzerland, Sweden, and Denmark to tax scheduled commercial banks to keep reserves in excess of their reserve requirements. Bank of Japan has also adopted a negative interest rate regimen since 2016, where scheduled banks will get minus 0.1 rates of interest on balances maintained at the central bank beyond the approved statutory reserves. The tool’s advantages and weaknesses are well known, the Bank of England can deploy it as a tool if it so feels is within the risk-bearing capacity of the country's banking system.

Negative interest rates

Negative interest rates are monetary tools which are used in view of the economic situation of a country and the prevailing market forces in the UK have already pushed the interest rates close to zero. It is a situation when the central bank put all its efforts to prop up economic activity levels in the country by pushing up inflation. In the implementation, it works as a penalty imposed on scheduled banks for keeping more reserves than they are mandatorily required, effectively encouraging them to lend out more. This measure is used in times of deflation when there is a tendency to hoard cash rather than spend it. There are, however, downsides to implementing a regimen of negative interest rates. While it penalises banks to pay interest on the excessive balances with the central bank, it forces them to lend when the risks may be too high as perceived by the banks to lend out money. Yet when the central bank may think that there is a scope for large scale economic slowdown, because of deflationary conditions or a major economic crisis like that of the current coronavirus pandemic, the risk of economic damage is far more in not lending than in lending. 

The other policy measures used by the government in the recent past

The coronavirus pandemic has caused a situation that has resulted in widespread economic damage in the United Kingdom. In the month of April, the GDP of the country shrunk by about 20 per cent and for the full year, it is expected to shrink by about 9 per cent. By all means, this situation is no different from a deflationary situation when production and demand both are at less than optimum levels.

As soon as it became apparent in late February and early March that the pandemic will have a deeply damaging impact on the British economy, the government rolled out a number of stimulus packages to help the country out of the impending hit. The central bank till that time had already lowered its interest rates to a low of 0.1 per cent and had been buying treasury bonds aggressively to push in more cash into the system. However, the lockdown imposed from 23 March 2020 for a six-week period forced almost all business activity in the country to a complete standstill. All the monetary measures were thus ineffective for that period as the problem was more structural and only effective policy measures could be employed to arrest the situation from deteriorating further. However, the central bank did implement a stimulus measure at that time, which produced almost the same effect as negative interest rates would. The government offered a loan scheme called the Coronavirus Business interruption loan Scheme (CBILS), whereby the central bank guaranteed loans extended by scheduled banks to support businesses during the crisis. While negative interest rates penalize banks for not lending out more despite their perception of risks, this scheme encouraged them to lend more with the central bank stepping in and assuming the additional risk. This measure, as well as a number of other measures rolled out at that time, were extremely helpful in arresting a deeper slide of the economy and stimulating a swifter turnaround when the lockdown opened.

The current state of recovery and inherent risks

Since the time the lockdown was removed in the month of May, the recovery of different parts of the economy has been disproportionate. Several important sectors of the economy have witnessed a strong rebound while others have been witnessing a weaker turnaround. This state of recovery is worrisome as many fear that the demand levels facing the better performing industries will not be sustainable beyond a certain point if the overall economic conditions in the country do not improve at a certain pace to support it.

Deputy Governor Dave Ramsden in a statement after the release of the monetary policy report has said that he expects that the economic recovery would continue but at a slower pace. The monetary policy committee of the bank, though recognising that the path of recovery may be slower than required, voted unanimously that no policy rate change is required to interfere in the ongoing process. Forcing the banks to lend by going outside of their comfort zones would be something that the central bank would try to avoid until it is absolutely necessary. There are several policy tools at the disposal of the government, which can be very effectively deployed to accelerate the recovery process without unnecessarily increasing the risk.

 

With Bank of England reducing the interest rates to a historic low level, the spotlight is back on diverse investment opportunities. 

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