The UK mustn’t fall for negative interest rates

This has not been able to take economies out of deflationary pressure

WITH the UK voting for Brexit, all eyes are on Bank of England (BoE) Governor Mark Carney as to what steps he takes to hedge the economy from unintended consequences. The global financial markets took a heavy beating post the referendum and the pound plunged to a three-decade low. The Brexit vote has already driven a risk-off reaction in the EU bond markets, with widening spread between the bond yields. In the near future, it may lead to accelerating inflation, a rise in unemployment and even a recession in UK.

So, what will the BoE do to minimise the impact of this adverse shock to the economy? The BoE governor has already stepped in with a pledge to provide $345 billion for the financial system. Ex-post to Brexit, in a statement issued by the BoE, Governor Carney stated that “the BoE has put in place extensive contingency plans. These begin with ensuring that the core of financial system is well capitalised, liquid and strong. This resilience is backed up by the BoE’s liquidity facilities in sterling and foreign currencies.” He also said the BoE has further measures if needed to deal with a “period of uncertainty and adjustment.”

So, what could be these possible measures at the disposal of BoE? According to JPMorgan Chase & Co., Goldman Sachs and ING Bank, the BoE could lower its key interest rate in its July meeting. A Bloomberg survey shows that in the event of Brexit, credit-easing measures such as quantitative easing and rate-cuts may be the immediate options resorted to. With the bank rate, key policy rate of the BoE, already trending at 0.5%, there is a real possibility of BoE entering the negative interest rate territory. Britain will not be the first country to experiment with negative interest rate policy (NIRP) in case of it being a reality, though the situation is not congenial for any reduction in interest rate. In a desperate bid to reinvigorate the economy, several of Europe’s central bank adopted a NIRP in 2014. Japan is the latest country to join this mad race with the Bank of Japan announcing in its January 2016 monetary policy statement a negative interest rate, of -0.1%, for current accounts that financial institutions hold at the Bank.

NIRP basically aims at penalising the commercial banks for holding excess reserve deposits with the central bank. In other words, instead of receiving money on deposits, banks will have to pay regu- larly to keep their money with the central bank. The idea is to incentivise banks to lend more freely to give a boost to dwindling credit growth. This in turn is expected to spur inflation and drive the economy out of recession.

Given that zero-interest-rate and quantitative easing failed to take advanced economies out of recession, will NIRP prove to be otherwise? NIRP has been in operation in some of the European countries for close to two years now. However, it has not really been able to take the economies out of deflationary pressure. As can be seen in the accompanying charts, countries like Sweden, Denmark and Switzerland, as well as Euro zone, are still struggling to achieve the desired inflation level of 2%. In fact, Switzerland, where the penalty imposed on for depositors on excessive reserves is the maximum, is witnessing negative inflation for more than a year now.

What explains this conundrum of insufficient inflation amidst ultra easy money policy being pursued? Remember that, by imposing penalties on excess reserves left on deposit with central banks, NIRP attempts to drive credit growth from the supply-side. However, incentivising banks to make new loans won’t bear fruit unless demand for such funds exists. Data shows that NIRP is yet to have any desirable impact on credit growth. In Denmark, for example, bank credit growth to non-financial corporations and households has remained negative since April 2015. This also substantiates the point raise by the Nomura economist Richard Koo who argues that “the focus should be on the demand side of crisisbattered economies, where growth is impaired by a debt-rejection syndrome that invariably takes hold in the aftermath of a balance-sheet recession.”

The NIRP may also have adverse impacts for banks. As highlighted in the Global Financial Stability Report April 2016, prolonged negative interest rate regime may “compress banks” net interest margin, a key source of bank “income”. However, the extent of the pressure on profitability will depend on to what extent banks are able to pass on negative interest rate to depositors. It will specially be difficult for banks with large retail depositors as it may be easier to pass negative rates to corporate clients than to retail clients. In fact, the data shows that banks are unwilling to pass on the negative rates to depositors for the fear of loss of customers. Consequently, the banks are also unwilling to cut down the lending rate much to be able to maintain their profitability. The net-interest margin of banks have remained more or less the same, post the adoption of NIRP.

Having analysed this, it would be judicious if BoE would not reduce interest rates in the near future. The BoE has held interest rates at a record low of 0.5% since 2009 and maintaining this status quo in rates is the right mantra to stem further macroeconomic repercussions ex-post to Brexit. In fact a sustained sterling slide may result in higher inflation owing to increased imports cost. BoE should therefore even consider tightening the monetary policy stance to keep inflation under check as well as to pre-empt capital outflows. Anand is is with the Indian Economic Service and is a research officer at the department of economic affairs, ministry of finance, and Chakraborty is associate professor, NIPFP