The news recently has been taken over with the measures the UK government is taking to get the UK Economy back up and running.
One of these measures is the reduction in interest rates.
The UK’s current base interest rate is 0.1%. This is the rate the Bank of England (“BOE”) charges commercial banks for money it lends to them or pays commercial banks for money they deposit with the BOE.
This is the mechanism used by the BOE to get you and I to either spend or save our money.
When rates are low we prefer to spend our money and buy assets cheaply often also using cheap debt. This positively adds money to the economy and stimulates production, which means more people are needed to be employed to help with production.
But what happens when no matter how low the rate goes we just don’t want to spend?
In this case the BOE may have to turn to the desperate measure of reducing the interest rate below zero, thereby setting a negative interest rate.
What does a negative interest rate practically mean ?
Interest rates are the price to borrow money. If for example you borrow £100 and are charged 1% per year interest, the cost of your borrowing is £1.
So does a negative interest rate mean the lender has to pay the borrower for borrowing ?
Crazily, yes that is exactly what it means!
Commercial banks depositing their excess money at the BOE will have to pay the BOE for the benefit of “storing” their money there. This should theoretically incentivise them to rather lend it out where they can still make a small amount of positive interest.
As there is competition amongst these commercial banks to lend their money to us, they have to also decrease the rates that they charge us to borrow and we start to see this in a drop in our mortgage interest rates and our other borrowings.
In some countries the mortgage rates have gone below zero. This means that if we were to borrow money to buy a house we would pay back less than we borrowed! We would however still have a monthly payment as we would still be required to pay back the mortgage just with no interest in fact we would be paid interest by the bank.
How surreal is that!
And doesn’t that sound like an amazing situation to find yourself in !
Well actually no, it isn’t all that rosy.
Firstly in those countries that had to take these extreme measures, the cost of properties have increased exponentially and now the average person cannot afford to buy a property.
Also negative mortgage rates mean negative interest on our savings accounts. And as a result unless we want to keep our money under our mattress, we would have to pay the bank for the benefit of keeping it there!
How does the economy benefit from negative interest rates if nobody is earning anything on their money ?
As mentioned previously the BOE reduces rates to get you and I to spend.
When we spend, we increase the demand for goods and services in the economy and incentivise companies to produce more to meet the increased demand. This means they have to spend more to buy the resources and employ more people to produce more.
As the UK now has a low interest rate, foreign savers have less interest in holding pounds as they aren’t going to earn a decent return. As a result they sell pounds resulting in a decrease in the value of the pound.
This means goods and services start looking cheaper to the rest of the world who also start buying UK goods further stimulating the economy.
What can go wrong?
Commercial banks have a huge amount of costs that they need to have covered by the interest rates they charge companies and individuals and if interest rates are kept low it may become suboptimal for them to continue lending at those levels, counteracting the objective of the BOE’s mechanism to get them to lend..
In addition you and I may decide now isn’t the time to spend even if interest rates are low and also hold onto our money.
Prices would drop further to entice us to spend and it may become unprofitable for companies to sell at the reduced prices leading them to cut production and downsize and the whole economy could head into a disinflationary spiral and ultimate stagnation.
Negative interest rates sound great until you look beneath the hood and get to see the negative implications they may have. Here’s to moderation in everything, even those things that cost us money!