Could interest rates turn negative?
Banks are paid bank rate of 0.5% on all of their reserves. This has been the case since quantitative easing (QE) began in March 2009, when QE meant that banks were in effect forced to hold large amounts of excess reserves that they did not need. (Before that, banks earned bank rate on their reserves as long as they were near their monthly target.)
So what would reducing this rate of remuneration achieve? At the very least, it would help to lower short-term market interest rates. The Fed has also suggested that it could help to signal policymakers' intention to keep official interest rates low.
It could also encourage banks to use their reserves to buy other assets. When discussing this issue at a Treasury Committee hearing in 2009, Mervyn King said that "the interest rate that we pay on reserves does affect the incentives which banks face to turn those reserves bank by bank individually into other assets" and that it would be useful to think about ways to encourage banks individually to convert some of their reserves into shorter term gilt holdings or other assets.
But the main hope is that it would increase bank lending. The lower the return a bank gets on its reserves, the greater the incentive to use those reserves to lend money at a higher rate.
Admittedly, the fact that banks are sitting on their cash when remuneration is only 0.5% suggests that cutting this to zero might not make that much difference. But the MPC could reduce remuneration to negative rates – i.e. force banks to pay to hold their reserves.
Indeed, Sweden's deposit rate is already negative.
Admittedly, this is not quite as bold a step as it might look. The Riksbank routinely keeps its deposit rate 0.5% below its repo rate and so when it cut its repo rate to 0.25%, the deposit rate automatically went to -0.25%. Yet the Riksbank's daily fine-tuning operations via the repo market mean that banks hardly ever use the deposit facility. Nonetheless, it has broken the myth that interest rates can't be negative.
Admittedly, a negative deposit rate could have some disadvantages. For a start, the traditional argument for not having negative interest rates is that people will simply hoard money in response. In the banks' case, this would mean withdrawing their reserves and storing them as cash in vaults.
But this costs money. So while it probably places a limit on just how negative rates could go, we doubt that a reserves rate of say -0.5% would make it worthwhile for banks to withdraw their reserves.
Meanwhile, cutting the reserves rate would, in the first instance, reduce banks' income (and one of the MPC's concerns about cutting bank rate below 0.5% was the effect on banks' profitability and therefore lending capacity).
And it might seem unfair to penalise banks for holding large amounts of reserves which have in effect been forced upon them. But the bank could partly get around this by reducing the reserve rate to zero or negative on only part of the banks' reserves, i.e. introducing a target level and only paying interest up to that level.
So how realistic is this option? The MPC did in fact give this idea serious consideration back in 2009, and at its November meeting "discussed the merits of changing the structure of remuneration on commercial bank reserves".
Although it did not make use of the option at the time, members did agree 'that it might be a useful policy tool in some circumstances'. The Fed also discussed it more recently, at September's meeting.
With the economy continuing to struggle the MPC will come under increasing pressure to think of more ways to stimulate the economy. We have already pointed out that cutting bank rate further is one option. But either in addition to, or instead of, this, negative deposit rates could soon be on their way.
Vicky Redwood is the chief UK economist at Capital Economics
Lower interest rates encourage people to spend, not save. But when interest rates can go no lower and there is a sharp drop in consumer and business spending, a central bank’s only option to stimulate demand is to pump money into the economy directly. This is quantitative easing. The Bank of England purchases assets (usually government bonds, or gilts) from private sector businesses such as insurance companies, banks and pension funds financed by new money the Bank creates electronically (it doesn’t physically print the banknotes). The sellers use the money to switch into other assets, such as shares or corporate bonds or else use it to lend to consumers and businesses, which pushes up demand and stimulates the economy.
This is more usually a feature of car insurance but it can also crop up in contents, mobile phone and pet insurance policies. An excess is the amount of money you have to pay before the insurance company starts paying out. The excess makes up the first part of a claim, so if your excess is £100 and your claim is for £500, you would pay the first £100 and the insurer the remaining £400. Many online insures let you set your own excess, but the lower the excess, the more expensive the premium will be.