Is the UK heading for negative interest rates?

In it's September report the Bank of England confirmed that it was exploring ways to overcome obstacles to negative interest rates. Opposite to all that we have been brought up with, it feels counter-intuitive, perverse even, but it could very well become a reality.

Back in 2008/09 central banks around the world responded to the global financial crisis with the two most powerful tools at their disposal - interest rate cuts and quantitative easing. In the UK, the Bank of England's base rate fell to an all time low of 0.25% and the commercial banks were flooded with newly created money, encouraging them to lend, albeit at very low rates.

By 2019 the base rate had gradually increased to 0.75% and quantitative easing was all but at an end. In the face of an economic collapse, the Bank's response to the pandemic was to cut interest rates once again, to a new record low of 0.1%.

It is widely expected that the economic effects of coronavirus will long outlast the pandemic itself. With the room for further quantitative easing seemingly limited, cutting interest rates again appears to be the only option, but how do you cut below 0.1%? Negative interest rates is how.

Why negative rates?

If a central bank sets a base rate below zero, commercial banks will be forced to lend to both businesses and consumers in order to maintain their revenues. Borrowers will be encouraged to spend rather than save and watch the value of their savings decline, thereby stimulating the economy. At least, that's the theory. There are both proponents and detractors - after all, as the old adage says, "ask two economists the same question and you'll get three different answers".

A crystallisation of the downside risks would leave the option of a subzero Bank rate as a serious possibility at some stage
Philip Shaw
Senior Economist, Investec Bank

​The use of negative interest rates has precedents. Japan, Sweden and Switzerland have all used them, Denmark currently has a base rate of minus 0.5% and the European Central Bank charges commercial banks 0.5% to use it's deposit facility. In May this year, the UK Government issued 3 year bonds at a negative rate of 0.003%, the first time the auction had gone below zero. Effectively, investors paid the Treasury to look after their money.

Savings and mortgages

Undoubtably, savers will be hit hardest. After all, the use of negative rates is designed to encourage spending. With bank deposits already paying negligible interest, depositors and investors will either watch the value of their savings decline or look to other investment options.

At minus 0.5%, Denmark's Jyske Bank currently has the lowest mortgage interest rate in Europe, proving the fact that they can exist, with the outstanding balance on the loan decreasing each month by the value of the negative interest rate. However, "fees and charges apply". It is unlikely that UK mortgage rates would see significant falls. No-one will pay you to take out a mortgage. In such an environment, banks are taking an increased risk each time they make a loan and they need to be compensated for that. Without a margin between what they borrow and lend at, they simply cannot survive.

The property market

Although the concept is designed to increase economic activity through higher business investment and consumer spending, the effect could be the opposite in one sector of the UK property market - the first time buyer. In a negative interest rate environment, banks may become more cautious in their lending to this segment - something we have already seen in recent months. This likely have a significant knock-on effect into the construction industry.

Banks may also be encouraged to lend more into the buy to let sector. This is another trend that has been increasing recently, on the basis that the larger deposits create a buffer against defaults and that residential property may be one of the few assets remaining that is backed by relatively strong income flows.

Will the Bank of England set a negative base rate? Such a fundamental change from historic norms may well depend upon the speed at which the economy recovers, which in turn will be dictated by the effects of the coronavirus over the winter months.

Update
On Monday evening, at a speech to the British Chambers of Commerce, the Governor of the BoE stated that negative rates had had mixed results elsewhere, but remained in the Bank's toolbox.