Have negative interest rates in the UK really moved closer?

The Bank of England’s instruction to commercial banks to prepare for a negative cost of borrowing is not all it seems, says Ben Chu

Bank of England governor Andrew Bailey is thought to be sceptical of negative rates (Reuters)

The headline from the Bank of England’s latest report released on Thursday is that “negative interest rates” have come a step closer for the UK economy.

Commercial banks have been instructed to “commence preparations” for the official cost of borrowing to go into reverse – and to be in a position to process negative rates, set by the UK’s central bank, in their own internal computer systems.

From that perspective this is a significant day in UK monetary policy history and for a country which has never seen a negative cost of borrowing imposed since the Bank of England was founded in 1694.

Yet consider the latest communications from the Bank of England in the round and one can take away the very opposite conclusion – that negative rates are, in fact, a more unlikely prospect than they were at the end of last year.

The Bank, for its part, has been keen to stress that its instruction to commercial banks to get ready for negative rates should not be seen as a “signal” that interest rates are actually set to be cut from their current historic low of 0.1 per cent.

It’s tempting to respond, a la Mandy Rice Davis, that they would say that, wouldn't they: Threadneedle Street never wants to be seen to commit to future rate moves, in any direction.

Yet there are strong reasons to take that guidance at face value.

One of them is that the Bank’s drawn-out investigation into the practicality of negative rates has concluded that many commercial banks would need up to six months to reconfigure their internal systems to cope with them.

Trying to rush it could, according to the Bank’s deputy governor Sam Woods, create “material risks to safety and soundness” of the banking system.

Saying banks should be ready to impose negative rates “after six months”, as the Bank’s monetary policy committee did on Thursday, is effectively saying that there is no possibility of negative rates until six months’ time.

And what will be happening to the UK economy in half a year?

According to the Bank’s latest projections it will be growing at a relatively decent clip of 5 per cent a quarter, as the vaccine rollout permits the lifting of lockdown and the opening up of the economy.

Indeed, so solid is this bounce back that there’s even excess demand in the economy in the Bank’s forecast by early next year, something in normal times markets would be trained to see as a prompt for rate rises not cuts.

One might quibble that this scenario is based on market interest rates, which do price in a slight cut of Bank rate into negative territory.

Yet examining the no-change scenario for rates in the latest Monetary Policy Report also suggests no expectation from the Bank that negative rates this year would impart any substantive boost to growth.

That’s certainly in line with the experience of other countries which have tried negative rates – too much is often expected of monetary policy in general when borrowing costs are already extremely low.

All that probably explains why markets, rather than interpreting Thursday’s announcement as a signal of impending negative rates and selling the pound, actually pushed up sterling against other currencies. And interest rate futures markets also signalled an expectation that rates would remain in positive territory throughout this year.

Some broader context is also useful.

While financial traders have spent much of the past year betting on the Bank taking the plunge into negative territory this year, many of their analyst colleagues judged that negative interest rates were only likely if the UK failed to secure a post-Brexit trade deal with the European Union.

The Christmas Eve deal with Brussels, mercifully, removed that outcome from the table.

While the Bank of England judges negative interest rates are a practical option, they are unlikely to be needed by the time preparations are complete

Martin Beck, Oxford Economics

"While the Bank judges negative interest rates are a practical option, they are unlikely to be needed by the time preparations are complete," notes Martin Beck of Oxford Economics.

The Bank’s governor, Andrew Bailey, denied that negative rates had been a contingency plan for to a no-deal Brexit on Thursday, but he also conceded that a large near-term downside risk has receded.

None of this means, of course, that negative rates are definitively off the table for this year. The recovery could be weaker than the Bank currently projects, perhaps because virus mutations make vaccines less effective than currently assumed.

And it’s certainly true that negative rates are much more viable for the next crisis.

But reading between the lines of the negative rates saga, it would appear that the Threadneedle Street sceptics – a group assumed to include the governor – have more reason to be satisfied than those who think the time has come for the Bank to go negative.