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What could negative interest rates mean?

11th June 2020

What could negative interest rates mean?

Back in the nineties, interest rates were double figures. If somebody had suggested that not so far in the future many European economies would be operating with negative interest rates, the reaction might have been to question their sanity. Had that same person then told you a year ago that a Conservative Government would be paying the wages of millions of workers, and subsidising the incomes of millions of self-employed people, it would have seemed beyond the realms of reason.   

But as the UK begins to emerge, bleary eyed, from months of lockdown, everyone is wracked with uncertainty about what will happen next and one consideration for the UK is negative interest rates. The Bank of England Governor has said that negative interest rates may now be needed in the UK as part of the response to the pandemic and to aid the economic recovery.  

The concern people have with negative interest rates is that they will end up paying the bank to hold their money, although ironically, many people already pay a current account fee to use the banking facilities. Whilst negative interest rates often feel a step too far for bank customers, the key reason for negative rates is actually to encourage corporate investors away from short term debt.

It is recognised that negative interest rates can play a broader short-term role in a steep recession when Governments are borrowing money. Most bond investors would be eager to avoid investing in negatively yielding assets and will either switch out of short-dated government debt with a negative yield, or if they want to continue to own short-dated bonds, then will switch to bonds issued by companies, rather than countries. Either of those outcomes has a short-term positive impact for the Government and the economy. 

While the rate cuts are likely to be small in practical terms, investors will go a long way to avoid buying an asset with a negative yield, so the impact could be significant. Commercial Banks will also be affected. They are required to hold cash or short-dated low risk bonds by regulators meaning they effectively have no choice but to own bonds with a negative yield. However, whilst banks are inclined to horde cash in a recession rather than lend it out into a risky economy, a negative yield may encourage them to lend and thereby boosting the level of activity in the economy and so stimulating growth. 

This all sounds positive for the economy until you consider some of the other aspects. One of the outcomes of a negative interest rate policy is that otherwise unsuccessful companies will always be able to refinance debt and so stay in business. Those companies are never successful enough to grant employee pay rises, so while unemployment remains low, so does wage growth. Keeping uneconomic companies afloat means the more productive companies in a sector are effectively dragged down by being unable to charge higher prices.

This hinders overall productivity, and eventually, economic growth, over the longer term.

If inflation and economic growth remain low without productivity improvements, the long-term growth rate in an economy becomes permanently lower.

When Governments are able to borrow money at such low rates, this will often appeal to politicians as it allows them to spend more, with the hope that this increased level of spending may bring the recession to an end sooner. However, it is not regarded as a long term solution and it can be fraught with difficulties.






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