BoE researching zero/negative interest rates

Date : 12 October 2020

The Bank of England and the Prudential Regulation Authority have written to commercial banks, requesting information on operational readiness for zero or negative interest rates.

Zero (negative) interest rate policy (ZIRP) has never been implemented in the UK before but has by the EU, Japan, and the USA.

In its letter, the Bank emphasises that ZIRP is not currently official policy and nor are financial firms expected to take any steps at this stage – research is for information only.

However, the timing of this announcement suggests that the Bank is anticipating further sever stress on the UK economy and is prepared to at least consider approaches not tried previously.

Low base interest rates are, however, already a reality for the UK as they have been for over a decade – the current base rate is only 0.1%.

ZIRP is an unusual monetary approach intended to increase liquidity in an economy by discouraging the holding of cash.

In ZIRP conditions, holding cash costs money, making it rational to lend it or to invest in some other way. In theory, ZIRP might create benefits through:

  • Encouraging lending – Funding investment by businesses
  • Increasing demand for assets - Raising asset prices
  • Increasing demand for goods and services – Helping to manipulate inflation and stimulate employment

Actual effectiveness is questionable. Japan used ZIRP in the 1990s following the collapse of its asset price bubble and it is still not clear benefits outweighed potential harms:

  • Impact on savers – Returns of long term, low-risk investments (pensions) may be undermined
  • Liquidity trap – Where lending offers low returns, lenders may prefer to hoard cash rather than take a risk
  • Poor investment decisions – Investors may be tempted to undertake riskier investments

Zero or negative interest rates set by the Bank of England would impact banks and financial institutions initially – but, historically, base rate cuts have been passed on to savers quickly.

The short-term impact of such policy on UK households is not clear. Many households have limited financial flexibility and their ability to respond to interest rate “signals” is likely to be low, especially due to coronavirus and EU Exit.

The longer-term impact of ZIRP on pension plans may be more of a challenge to prosperity and demand.

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