Sunday, June 21, 2020
The floor's the limit - we must avoid negative interest rates
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.

As widely expected, the Bank of England announced additional quantitative easing (QE) on Thursday, pumping in a further £100bn. The Bank’s monetary policy committee (MPC) did not cut its main interest rate below zero, leaving it at 0.1%, despite some suggestions that it might do so, and hints from some members that negative rates are part of its armoury.

I shall come on to negative rates in a moment. It may seem a little odd, when the Bank announces a further £100bn of QE, to describe the decision as hawkish, but it was. Instead of a unanimous decision in favour of expanding the asset purchase programme, one member, the Bank’s chief economist Andy Haldane, voted against because “the recovery in demand and output was occurring sooner and materially faster than had been expected at the time of the previous MPC meeting”.

In general, while noting that the risks in the labour market were on the downside, the MPC said that emerging evidence pointed to a less severe Covid-19 downturn than it had set out last month in its May monetary policy report. The Bank, it seems, has moved from the gloomy end of the spectrum into the pack.

It has the same evidence to look at as the rest of us, but it also has a little more, in the form of the reports from its network of regional agents around the UK and from its decision-making panel (DMP), which consists of 8,000 chief financial officers from small, medium and large businesses. It is run from Nottingham University.

The latest survey, carried out last month, showed that businesses expect sales in the current quarter to be 42% lower than they otherwise would have been, and investment 43% down. This is very gloomy but marginally less so than in April, when the expectations were for second quarter falls of 44% and 50% respectively.

The survey also shows the impact of the chancellor’s furlough scheme, with firms now expecting a 6% drop in job numbers this quarter, down from 18% in April.

Perhaps most interesting was what the survey showed about the shape of the recovery. As noted, firms expect sales to be around 40% below normal in the current quarter; 30% below in the July-September quarter; 20% down in the final quarter of this year and 10% in the first quarter of next year. This is the economic “V” I have often referred to; the economy picking up quarter by quarter as activity returns.

What is also clear, however, is that there will be lasting negative effects elsewhere. Business investment will lag the recovery in sales and will still be 20% below normal in the first three months of the year. The employment shakeout, meanwhile, will be most intense in the post-furlough period at the end of the year, when firms expect a hefty 10% drop in job numbers.

It is a very plausible recovery scenario, but we are not out of the woods yet, and we are not beyond the point at which the Bank will have to consider further QE or negative interest rates. If the economy were to suffer a further setback, say from a second wave of Covid-19 in the autumn, all options would be back on the table. Negative rates have been avoided so far, but the story may not yet be over. I hope it is, but we shall see.

If you think that negative interest rates do not feel right, I agree. They turn the basics of finance on their head. An interest rate is the reward for deferring consumption from now until later. By the same token, borrowers have to pay an interest rate to spend money now they did not have. Only if there is an overwhelming case for bring forward consumption from the future is there an argument, though negative rates may or may not achieve this. Nor, to bring it to the current debate, would cutting interest rates on commercial bank reserves at the Bank necessarily make much difference to the amount that banks lend into the economy.

A better case for negative interest rates would be if current and expected inflation was itself heading below zero, in other words into deflationary territory. A Bank rate of 0.1% with inflation at 2% means that official interest rates are negative, in real terms, by almost two percentage points. A 0.1% rate with -2% inflation, falling prices, represents a significantly positive real interest rate.

Though inflation is currently low, at 0.5%, and set to fall further over the summer, it is expected to rise again as lockdown eases further and a degree of normality returns. Some, like the veteran monetarist economist Tim Congdon, suggest that current very high levels of money supply growth point to a significant inflation shock to come. The inflation outlook does not offer an argument for negative interest rates.

There are two further points. The first is that one thing we have discovered from recent experience is that once a new level of interest rates is established, it is very hard to get out of it. When the Bank cut rates to a record low of 0.5% in March 2009, most people, and all members of the MPC, expected it to last for no more than 12 months or so. In fact, it lasted for more than seven years, until August 2016, at which point there was a cut to 0.25%. Not until August 2018 did the rate move back above 0.5%, and then only to 0.75%, and temporarily.

Forecasters do not expect Bank rate to rise above 0.1%, the current rate, for perhaps 3-4 yeas. Were the Bank to cross the Rubicon and move to a negative rate it could take a very long time to get out of it.

The final point is that, for the most vocal advocates of negative rates, like the US economist and former International Monetary Fund chief economist Kenneth Rogoff, it is no use interest rates being a little bit negative, say by 0.25%, they need to be “deeply” negative.

This really does turn finance on its head. It calls into question the continued existence of cash, which holds its value, against deposits, which would lose value. Rogoff is the author of The Curse of Cash, published four years ago. One of his arguments was that phasing out cash, beginning with large denomination notes, would leave more room for negative rates.

It may be that the danger has passed, and that, if the Bank’s more optimistic noises on recovery are anything to go by, it will not need to contemplate negative interest rates. Let us hope so, anyway. They are a bad idea, and we do not need them.