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What do we mean when we talk about the Policy Rate or Bank Rate?
The Policy Rate is set by the Bank of England Monetary Policy Committee (MPC). The Policy Rate is the interest rate the Bank of England pays to commercial banks that hold money there. This rate in turn influences the rates those commercial banks charge people and businesses to borrow money, as well as how much they pay to businesses and people when they deposit their savings at the commercial bank. A lower rate incentivises borrowing, current spending and investment, while a higher rate incentivises saving, deferred spending and investment. In this way, central bankers can use the policy rate to cool or stimulate the economy.
What is the job of central bankers?
Mandates differ slightly from central bank to central bank, but generally central bankers are in charge of keeping economic growth sustainable, employment levels high, and prices stable. Central banks generally consider general growth in prices of 2% per year to be a safe rate of change, often referred to as the rate of inflation. If inflation is too high or too low it can hurt households and the economy. The Bank of England currently has a 2% inflation target set by the Government.
One factor that is thought to have a powerful influence on the path of inflation is expectations about future inflation. Inflation expectations are thought to depend on current inflation conditions, current interest rates, and how central banks are expected to respond to inflation. Central bank credibility in responding to inflation (i.e. being able to achieve your inflation target) is believed to be important for achieving price stability.
Why would the MPC set Bank Rate below zero?
Globally, policy rates have fallen over the last thirty years. Central bankers believe that this is partly due to a fall in the ‘equilibrium interest rate’. This is the interest rate at which monetary policy is neither expansionary nor contractionary – where the demand for money matches the supply of money. Much of that fall can be explained by structural factors such as an ageing global population and slowing productivity growth.
Policy rates were lowered significantly in the wake of the Global Financial Crisis in order to support growth and inflation, and they have remained at historically low levels ever since. The economic shock caused by the Coronavirus pandemic has caused another knock to growth and inflation, causing many policy makers to cut already low rates even further. The Policy Rate is currently 0.1% in the UK. Given that the near term outlook for growth is weak, the Bank of England are likely to need to cut rates further in order to stimulate the economy. If interest rates cannot go below zero, this only gives the Bank of England ten basis points to play with. If interest rates can go below zero, the Bank clearly has more room.
How far below zero can rates go?
At a certain policy rate, policy makers theoretically reach an ‘effective lower bound’ (ELB). This is the level below which it is judged that rate cuts stop boosting inflation and growth, or that adverse effects, in areas such the financial sector, outweigh the economic benefit.
The Bank of England historically believed this rate to be above zero in the UK. Because the Policy Rate was close to the ELB, the Bank of England used other monetary policy tools (once called unconventional tools) in the wake of the Global Financial Crisis.
The ELB may vary over time due to changes in economic or financial structures or prevailing economic conditions and will likely vary across economies. Note that Denmark, Sweden, Switzerland, Japan and the European Central Bank have all implemented negative policy rates in recent years.
Do negative rates work differently?
In some respects, negative rates may impact the economy in the same way as positive rates – lower (more deeply negative) interest rates incentivise borrowing and current spending and investment and disincentivise saving and deferred spending and investment. Lower interest rates also increase the present value of assets. A lower interest rate may also cause the currency to weaken, boosting inflation temporarily via the channel of increasing import prices, and boosting the affordability, and therefore sales, of exports.
However, in some ways the transmission may be different, including via the channel of household deposits. Commercial banks cover their costs by paying less on saving than they make on lending – this is known as the interest margin. Analysis shows that, during periods of negative rates, household deposit rates typically did not fall below zero – commercial banks may not attract or retain deposits at negative savings rates. However, business deposit rates are more likely to turn negative.
If deposit rates cannot fall below zero but some of a commercial banks’ existing loan book is linked to policy rates, which has fallen below zero, then banks’ interest margins decline, hurting bank profitability. The more reliant a bank is on household deposit funding (as opposed to other forms of funding that might be connected to the Policy Rate), the greater the impact on its profitability. In the UK, smaller banks and building societies are generally most exposed to these risks.
To sustain interest margins and profitability, banks might choose not to pass on the full reduction in the Policy Rate when setting new lending rates, or to restrict lending. This would reduce the expansionary effect on growth of negative policy rates and could even restrict credit availability.
What does the Bank of England’s Monetary Policy Committee think about negative rates in the UK?
The MPC is currently reviewing the monetary policy toolkit, including negative rates. In the August Monetary Policy Report the MPC commented that:
“negative policy rates at this time could be less effective as a tool to stimulate the economy…because banks’ balance sheets will be negatively affected by the period of severe economic disruption… they have an important role to play in helping the UK economy recover by providing finance for individuals and companies.”
The Bank is assessing the operational viability of a negative rate. In October, Sam Woods, deputy governor of the Bank of England, wrote to banks asking about their 'operational readiness' for a zero or negative Policy Rate, specifically “information about current readiness to deal with a zero Policy Rate, a negative Policy Rate, or a tiered system of reserves remuneration – and the steps that you would need to take to prepare for the implementation of these”.
In the past, MPC members were unenthusiastic about negative rates. As recently as 2016, the bank judged the ELB to be ‘close to, but a little above zero’. In recent months, the idea of negative rates has been increasingly discussed.
Negative or not, UK Policy Rate is likely to stay low for some time. Futures markets are implying negative interest rates by next spring. Negative rates could support growth and inflation in the UK, but there are also reasons to think they may not be that effective.
Putting negative rates on the table as a viable policy tool offers the MPC more scope to support the economy during the current period of weak growth and inflation. Having negative rates in the toolkit could be crucial in enabling the MPC to meet its 2% inflation target by controlling inflation expectations.
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