Why negative interest rates would make the UK economy worse rather than better

Yesterday even the mainstream media woke up when something I have been discussing on here for nearly two years flashed up on their radar. The specific occurance was when Deputy Governor of the Bank of England Paul Tucker mentioned negative interest rates. Actually the accident prone Mr.Tucker -remember his gaffes in the Libor scandal- did not mean what most have taken  from that mention and his announcement that not only would it be a “radical idea” but also the following.

This would be an extraordinary thing to do and it needs to be thought through very carefully

As you can see he was giving the impression that something really significant would happen here. Whereas he was specifically discussing a technical move between the Bank of England and banks. Oh dear another mistake as we again review how such a gaffe prone individual has ended up with an index-linked pension worth around £5 million.

Is the Bank of England about to introduce negative interest rates?

The latest minutes of the Monetary Policy Committee suggest that Paul Tucker’s idea was rejected. Indeed  he did not even vote for a move in this direction himself,perhaps he forgot?

The Governor invited the Committee to vote on the propositions that:

Bank Rate should be maintained at 0.5%;

Regarding Bank Rate, the Committee voted unanimously in favour of the proposition.

Actually there are a row of issues here. Firstly there are two 0.25% cuts available to the MPC before it would push official interest rates negative. So you might think that Paul Tucker might vote for them before his “radical idea”! Also none of his colleagues seem keen. This matter has come up many times with the initial rejections a couple of years ago being based on fears of what damage would be done to the banking system and believe it or believe it not whether computers there would be able to cope! If we step back in time to then there was a Cheltenham and Gloucester mortgage which for a period of four years tracked the base rate less 0.54% if I recall correctly so borrowers were owed money albeit small amounts.

Even now the MPC has concerns on this issue as illustrated by the quote from the latest minutes below.

These included: purchases of other assets; a reduction in Bank Rate; and changing the marginal rate of remuneration on banks’reserves at the Bank of England. The Committee had noted drawbacks with each of these options in the past; those drawbacks remained. The Committee would nevertheless continue to examine all of the policies potentially available to it.

So not keen on them (for now) including what Paul Tucker really meant to say. Amazing isn’t it how often people regularly described as intelligent are unable to articulate what is not that complex an issue? As they often do not appear to be intelligent to me that word went into my financial lexicon for these times a while back.

What did he mean?

Let me explain. Right now banks hold money with the Bank of England for various reasons but one of them is the security provided in what are very uncertain times and in return for this the receive the base rate which is currently 0.5%. Paul Tucker suggestion would be to cut this to discourage them from doing so and the logical step actually might be to cut it to zero. However the European Central Bank has done this and it made no real difference as banks continued to deposit money with it although slightly bizarrely they did change accounts which confused some.

So Mr.Tucker has realised that negative interest rates might be required here but I wonder if he has considered how negative? The ECB evidence above suggests that banks might be as hard to shift as barnacles on a boat and they might require a fairly heavy dose of negative interest rates. Also they could simply pass the costs on to their borrowers and savers which would mean that Paul Tucker would have scored yet another own goal.

If we return to the plan which Paul Tucker hopes would take place is that he would force banks to take money away from the Bank of England and they would then lend it on. The fundamental problem which this ignores is that banks right now are unwilling to lend as otherwise they would be doing so on a larger scale and that this measure does not address this. Indeed what if they treat this as an increase in their costs and simply keep the money at the Bank of England and raise their borrowing rates to get the money back? After all every policy intiative so far has ended up improving and not reducing bank profitability.

What about savers?

Here we have a difficult conceptual issue as whilst there is scope for savings rates to be reduced as they are around 2% there are problems here too. For the economy as a whole the contractionary effect of reducing savings rates has been much stronger than the Bank of England expected and in my view has been one of the reasons their policy has not worked. So further reductions would have this contractionary effect before we get to the issue of how you make savers accept an interest rate of below zero. There is plainly a large danger that they would withdraw their money from the banks at this point.

Such deposit withdrawal would pose quite a few questions. Firstly official policy -unless they have forgotten- is for banks to have more not less retail deposits as a way of avoiding the problems that befell Northern Rock. Ooops! Also if it led to savers hoarding cash via banks notes there are plenty of dangers here such as theft and fire.

Borrowers too

You might think that reducing borrowing rates should that actually happen, rather than the possible rises discussed above, would lead to more borrowing. Except that so far such moves have led to borrowers being much more prone to deleveraging or paying off borrowing  rather than borrowing more. This has no doubt been influenced by the lack of willingness of our banks to lend. So the lending boost if the evidence so far is any guide would be likely to be very weak if it existed at all.

Actually in real terms we do have negative interest rates

If we subtract the rate of inflation from official interest-rates then they are already substantially negative. For example with the official Consumer Price Inflation measure being at 2.7% that leaves us with a -2.2% rate and the Retail Price Index at 3.3% means that it is -2.8% on this measure.

Comment

So as you can see Paul Tucker did not actually mean negative interest rates for the whole system. As we examine the possibility we yet again see the possibility and maybe probability that it would increase borrowing rates whilst doing nothing for the volume of bank lending. There are also plainly issues for savers.

Such a move would be likely to spread into other interest-rates including the base rate as the Bank of England appears to be forever looking for new ways to loosen monetary policy. Whilst I think it is a bad idea I have been afraid for some time that the UK might get negative official interest-rates. As they trawl through, talking down the exchange rate of the pound, more Quantitative Easing, and other schemes such as the Funding for Lending Scheme and they continue to fail then under my “More,More,More” theme in a combination of desperation and panic they could cut interest-rates further and send them negative.

What they would be ignoring by so doing is that if cutting the base rate by 4.5% from 5% to 0.5% has had so little effect what exactly they expect to happen if they continue on this road?

LBC Radio

For those listening to this I was/am Shaun from Battersea as I thought that as it is a specialist topic I had expertise to offer about negative interest rates. Indeed there was some impact as I note that James O’Brien changed his introduction to reflect what I had told them. Unfortunately however as I explained the consequences for savers he went “Thanks Shaun” and cut me off as this was unwelcome for his weight lifting analogy!

You can but try………

This entry was posted in Banking Reform, Banks, GDP, General Economics, Inflation, Quantitative Easing and Extraordinary Monetary Measures, Stagflation, UK Inflation Prospects and Issues and tagged , , , , , . Bookmark the permalink.
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  • Anonymous

    There is plainly a large danger that they would withdraw their money from the banks at this point.

    Indeed, but for rational investors that point was reached when the post-tax return on savings fell below the level of inflation experienced by those investors. Given that a large slice of those investors must be paying tax at 40%, there clearly is a large inertia effect here, or simply the lack of any available investments.

    I have great difficulty with the current interest rates. Of course it’s delightful for those with large debts, but did the BoE really have to go to such extremes? A base rate of 2% would be much more equitable between sectors of society. Many people with tracker and similar mortgages have had a very large gift from society, one that I suspect few would recognise. Small businesses, not all of which are on the ropes, have also had an indiscriminate subsidy. To ‘protect’ the few who overborrowed, all are being rewarded with the lowest interest rates in two generations. But every saver is being charged for this. I’m astonished that savers (who must by now know what is happening) put up with these clearly discriminatory policies. Not one peep of protest has been heard yet, and shortly it looks as if things will get worse.

  • anteos

    b, there has been protests. Save our savers has been very vocal in trying to protect savers, even going along to the treasury select committee.

    http://www.saveoursavers.co.uk/

    the lack of support from any of the political parties has been shameful.

  • DaveS

    Firstly the banks can’t led because they would need more capital to lend and they are supposedly being threatened with increased capital requirements in the future.

    Secondly the banks are sitting on a stack of bad loans that haven’t been recognised and when they finally are it will further hit their capital.

    And what happened to the idea that the whole crisis was caused by too much debt ? That the banks had to de-leverage and shrink their balance sheets.

    We are constantly being told that businesses are awash with surplus cash that they are unwilling to invest due to lack of confidence. So Tucker really means he wants the banks to lend to consumers and really that means mortgage lending. They want to try and get house prices on upwards move again because this boosts consumer confidence and hence business confidence and then GDP grows and crisis is over. Its deja-vu all over again.

    I would like to say they are idiots but I am sure even they are capable of understanding all of this. But they have no idea how to create real growth so they are now resorting to desperate tricks to try to recreate fake growth based on excessive debt.

    No wonder I am pessimistic.

  • ernie

    Thanks Shaun – the main point I took from your post was that the reduction in base rate from 5%, which happened now some years ago, has made no difference at all to borrowing appetites. Indeed, even in mortgage finance deleveraging is still going on. This indicates that all those who were willing to take on debt have already done so, since they were quite willing to do so at much higher interest rates (see 2008 crash). Therefore, the problem is not a lack of lending, it’s a shortage of credit-worthy borrowers. This situation has actually been exacerbated by the crisis, since a “batten down the hatches” mentality is now firmly set in. Those who could borrow due to their better overall credit position are not willing to do so. Continued measures which smack of crisis/panic will only serve to increase this tendency to stay under cover. Until and unless interest rates are raised to encourage proper investment of capital (not worthless stock speculation) this will not change. This may be counter-intuitive but I believe it to be correct.

  • Anonymous

    Shaun,
    Currently paying 9.45 euros a month for a French bank account – this appears to be the going rate – offset by also having a savings account that pays interest at the end of the year.
    UK banks trying fees for premium accounts with benefits?
    BoE base rate still irrelevant for most people as you have pointed out many times eg credit card & payday loan rates

    I understand that in the USA that after foreclosure banks can not pursue mortgagees for additional money – perhaps if adopted UK banks would be more careful on home loans and we avoid excessive housing bubble?
    Housing still special case no capital gains on residence and buy to let rampant as pension alternative?

  • max

    a PERFECT summary DaveS.

    The whole system is fatally broken.

    They can’t reduce house prices to affordable levels as the banks will go bust. But at these levels the loans made are dangerous and nobody can anyway afford them with inflation so high.

  • Robert S

    Shaun,

    There’s two things I would love to know:

    1. Why do the banks deposit their money with the BoE every night? Surely, they’re banks in their own right? What do they thinks going to happen to it, and what makes the BoE more secure?

    2. Instead of negative rates, why can’t they do what they do to ISA account holders, and refuse to receive money over a certain amount? In The Telegraph article I was reading, they discussed how they would have have to allow, say, £1bn to be deposited with the 0.5% rate to assist the building societies, credit unions etc, and anything over £1bn there would be a negative rate. Damn sure if ISA savers can’t deposit their full amount, then banks can be made to do the same thing. Madness, I tell you, madness! And this fool is given a pension!

  • forbin

    DaveS has made a good summary , but we are here because out illustrious leaders are ignoring the Big Debt issue

    yes its those darned Banks again

    they are bust , still bust and if ever we get a house price correction – be bust even more !

    but as I have often noted – governance of the people by the Banks for the Banks

    Really until that changes then nothing will

    Forbn

  • forbin

    Hello Shaun,

    indeed it would be madness to negative interest rate , so

    1, current BoE rate has made little difference to the lending interest rates

    2, what difference has been made had been to high deposit mortgages – now call me a fool if you like but as an average joe, very few people get these rates – maybe those but to pillage , sorry let , wallas but in the main it leaves the impression the bank lenders have factored in large deposits to cover a large house price correction ….. hmmm and you know I ain’t gonna borrow because I’m not that stupid and I think most others are thinking the same

    3, If it cost me money just to have a savings account , and this is where this applies as most have bank accounts and these have something of a utility worth, then expect a massive rush out of the banking system

    followed by us reversing the trend to have bank accounts/savings and going back to a cash economy

    think what that will do to VAT and business ….. the banks will need another bailout as well

    perhaps really someone , somewhere, will grown some and let these banks go bust…. then maybe we can then recover!

    Forbin

  • JW

    Hi Ernie
    I believe you are correct. But they are scared higher interest rates will cause defaults and bank collapses. They are paranoid about collapse of the entire financial system, banking and non-banking. So the policy is to ‘protect’ whats gone before rather than promote what can happen now and in the future. Consequently we have ‘zombie’ everything; banks, businesses, households, nations.

  • Rods

    Hi Shaun,

    An excellent analysis of what the fools at the BOE think.

    “Oh dear another mistake as we again review how such a gaffe prone individual has ended up with an index-linked pension worth around £5 million.”

    One rule for them and one for the plebs where the maximum private pension cap is being consistently reduced, and with the current rate of inflation will not provide an adequate pension for somebody who is 40 and plans to retire at 70. Now who are worth more to society, failed BOE officials or directors of world class businesses like Tesco, Rolls Royce, Vodafone etc.

    From 1982 to 2012, prices on average rose by 299% and an annuity for Joint life, 3% escalation taken at 70 is currently £4200/£100,000. Now after 25% tax free cash this leaves a pension of £39,375 with a estimated real value of £13,125. Nobody is going to live like a BOE Lord on this!

    This cap has been consistently reduced over the last 30 years as it was much higher when I started paying into a pension.

  • Patrick

    I’d add that it’s not just a case of credit worthy borrowers, but that inflationary increases and asset bubbles have made everything bar consumer tech much less affordable.

  • economymad

    Good post Shaun, and great comment DaveS, I really have nothing more to add as you pretty much covered exactly what I was thinking.

  • Anonymous

    Hi barncactus
    You have picked on a level which is where I always thought that the liquidity trap began or around 2% interest rates. I believe that since then any gains from borrowers have been lost on the other side of savers and pensions and particularly sadly maybe more has been lost than gained.
    This is why if I got on the MPC I would be looking to put that right.

  • Anonymous

    Hi Guys
    If I can reply to all of you at once then as I have explained above to barncactus this is one of the reasons why I set out my stall a while back and would look to get base rates back to 2%. I have discussed in the past that I would have raised interest rates.
    However there would be a lot more to my strategy as just in one example i think that many credit card and overdraft rates are usury. So my plan would also involve reconnecting official base rates with actual interest rates that people get and pay.
    I intend to re-update on my plan to get us out of this mess soon but for now I will leave you with the thought that was too difficult for James O’Brien at LBC Radio to comprehend which is if cutting interest rates by 4.5% hasn’t worked why will cutting further suddenly succeed?

  • Nico

    Correct. I fall into that category. I would be prepared to borrow significantly and pay a higher rate of interest than rates are currently if I believed the asset (a house) I would be acquiring was decent value. As it is I think the assets are being artificially propped up.

  • Anonymous

    Hi Chris

    Thank you for reminding me that in some countries bank acounts do come with a fee. Every now and then they try to swing that in the UK too!

    It would appear that the housing and banking sectors are one inter-twined special case does it not?

  • Anonymous

    Hi RobertS

    1. It used to be that banks were required to hold money at the BoE when that changed it still likes them too as it helps it to implement monetary policy and in these times they like the security of it. The security comes at the end from the fact that the BoE controls the currency so can always repay £ debts and it has taxpayer backing too.

    Here are its views on this.

    “Reserve balances: current account balances held by commercial
    banks and building societies at the Bank. The Bank pays Bank Rate on reserve balances – a key part of the implementation of monetary policy. Reserve balances can be used by commercial banks to make payments and constitute a high quality liquid asset for them to hold. The sharp increase in reserves balances since March 2009 reflects the fact that asset purchases under the MPC’s policy of Quantitative Easing have been financed by increasing reserves balances.”
    Yep QE yet again….
    2. I need to think more about the Telegraph suggestion as on first sight it seems to be bound to be fiddled and circumvented.

  • Anonymous

    Hi forbin
    The last time something had to work like this we ended up with the word disintermediation which without the details means (unexpectedly of course..) it didnt…

  • Anonymous

    Hi Rods
    Thanks and I have been thinking about annuties but the recent rally in the Gilt market has briefly stymied me but it is on my mind. As to the pension rules I did do some work in that area and whilst for most of us the changes are out of out leagues there are issues.
    1. Long-term planning requires exactly that rather than annual fiddling.
    2. As you say some animals are more equal that others.

  • Anonymous

    Hi Nico and welcome to my part of the blogosphere
    Unfortunately if we look at say the US stock market closing well above 1500 tonight on the S&P 500 we see that so many asset prices are (in my opinion) like that.

  • Paul C

    Great discussion thread from all, really covered all of the angles on interest rate manipulation. These policies are designed to protect the economic system as we know it, the banks of course but also the “historic” wealth of a generation of people.

    Principally the folk that were born in the 1950′s and who purchased properties in £5K to £75K price bracket and now own essentially the same bricks and mortar (but with uPVC windows and central heating) valued at £150K to £750K. So this is a generational “put”, of course there are the savvy BTL folk and serial doer-uppers who along with the generational cohort are very interested in preserving this status quo.

    The politician’s and banks together know that their future is tied to protecting this established way of working, Some retiree’s may complain about their poor saving returns however their £500k home asset provides a nice cushion and still a sense of personal success.

    Of course this does dis-enfranchise the young and unfortunate renters but I can only imagine that the aging cohort of established owners expect to subsidize their following generations from their “accumulated wealth” (or simply perhaps spend it on cruises in the Mediterranean sea).

    An economic reset that allows people to recognized for their actual economic contribution and re-establishes a fair cost of money (interest rates at 3-6 %) would be desirable from a human fairness perspective. Government & Banks have kept this show on the road since 2007 so you have to give these manipulators some recognition but it is clear that every week it is costing more in financial and non-financial measures.

    Let us wonder at how things may develop in 2013……

    Paul Chadwick BSc Econ