Sunday, February 07, 2016
Britain should never join this negative interest rate club
Posted by David Smith at 09:00 AM
Category: David Smith's other articles


My regular column is available to subscribers on This is an excerpt.

Negative interest rates are in vogue. The Bank of Japan a few days ago joined a club which includes Switzerland, Denmark, Sweden and the European Central Bank (for one of its key rates) in pushing the interest rate dial below zero. Three of the world’s biggest central banks have negative rates. I shall come on to the Bank of England in a moment.

After a long period in which interest rates have been close to zero and central banks have engaged – and in some cases are still engaging – in large-scale quantitative easing, it appears that it is still not enough. At least five central banks think negative interest rates are now necessary. Could they ever become the norm?

Negative interest rates are still a strange phenomenon. The idea that anybody should pay for the privilege of depositing funds runs counter to the normal rule of “time preference”, that any rational person, or business, would rather spend now than later. The usual way of dissuading them from doing so, in other words encouraging them to save rather than spend, is an interest rate incentive. We will defer consumption if it is worth our while. That is how it works.

Central banks are different. The interest rate they typically set is on the reserves commercial banks hold with them. In most cases, commercial banks have to hold at least some of those reserves, for prudential and other reasons. They are, in that sense, a captive audience – up to a point.

As Paul Sheard, chief economist at Standard & Poor’s puts it: "Central banks can do this because they get to determine the total amount of liabilities they issue, giving them the unique ability to set both quantity and price. In the real economy, borrowers can't usually force lenders to lend to them.”

So, even in countries which have adopted negative interest rates, ordinary savers are unlikely to have to pay for the privilege of putting their money in the bank, though that may be of small comfort to those who have been enduring near-zero returns for years.

What is the point, then, of negative rates? When the Bank of Japan, or another central bank reduces rates below zero, it is trying to do two things. It is sending out a signal to the markets that whatever expectations they may have of future interest rate rises, they can revise them down. And, by penalising commercial banks – effectively taxing them on their deposits at the central bank – it is hoping that they will use any excess reserves (those above what are required by the regulators) will be used more productively; lending them into the real economy.

Negative rates are, as I say, still a strange idea. In the crisis, and in the post-crisis period, we have, to paraphrase Lewis Carroll, got used to believing many impossible things. This is just the latest.

It is perhaps not so strange when we think about the “real” interest rate; the interest rate adjusted for inflation. A negative “real” rate has been the norm for many years. Rates set by central banks have been well below inflation since the crisis hit.

In Britain in the period since Bank rate was reduced to 0.5% in March 2009, consumer price inflation has averaged 2.4%, implying an average negative real interest rate of almost 2%; -1.9% to be precise. At its worst, during 2011, real interest rates were negative by almost 5%.

Logic would suggest that if a negative real interest rate averaging nearly -2% has been needed to generate recovery over the past seven years then, at a time when inflation is close to zero – and set to remain so for some time – real interest rates might currently be too high.

So, while inflation of 2% or so allowed the Bank to pursue a negative real interest rate strategy by stealth, zero inflation could mean it has to do so in an upfront way. Actual, or what economists would call nominal interest rates, might also need to be negative, perhaps significantly so.

Logic can only take us so far in this, however. There are important practical and symbolic differences between a negative real interest rate achieved when both rates and inflation are positive, and a negative real rate that can only be achieved by cutting below zero. Even then, as noted above, a reduction in general rates throughout the economy would provide a powerful incentive for everybody to keep everything in cash. This was the conundrum addressed by Andy Haldane, the Bank’s chief economist, when he mused a few months ago that negative rates might require the abolition of cash.

So what of the Bank? It, and its governor Mark Carney, tried to be both dovish and hawkish on Thursday, with the publication of the quarterly inflation report. The dovish signal was that the only member of its monetary policy committee (MPC) to have been voting in recent months for a rate rise, Ian McCafferty, has thrown in the towel, for now at least.

The hawkish signal was that the MPC think markets have got ahead of themselves. Ahead of Thursday they were pricing in a 30% chance of a cut in rates, with no increase until 2018. The MPC, Carney said, has not even discussed the possibility of negative interest rates, and believes rates will need to rise to hit and maintain inflation at the 2% target. Not yet, but they will go up. Pressed repeatedly on rate cuts, the governor batted the suggestions away.
This is, as Bank-watchers know, no guarantee but it looks to be a pretty firm stance. The Bank is not even flirting with joining the negative interest rate club. It does not intend to turn Japanese.

That is good news. Britain’s economy is strong enough not to need further monetary help, even with the Bank’s modest trimming of its growth forecast. And, having argued a couple of weeks ago of the dangers of leaving rates too low for too long, I am not now going to argue that they should be cut, let alone go negative. To reprise one of the arguments then, a good way or persuading people and businesses that something must be badly wrong, thereby hitting confidence, would be a negative interest rate. This a club to which we do not want to belong.