Imagine the scene. It’s a year from now and Covid-19 hasn’t gone away. The economy is in the doldrums, with unemployment rising and inflation well below its 2% target. The Bank of England has been pumping money into the financial system through its quantitative easing (QE) programme but to little effect. What’s its next move?
One option for Threadneedle Street would be to say it was effectively out of options and pass responsibility for further stimulus over to the chancellor. After more than a decade of ultra-low interest rates and hundreds of billions worth of QE, there is a strong case for fiscal policy – tax cuts and public spending increases – doing the heavy lifting.
There would, though, be one last thing the Bank could try and that option – negative interest rates – is now under active consideration. In the event that the economy does materially worse than the Bank’s monetary policy committee is predicting, the official interest rate would be cut below zero.
In the past, notably during the financial crisis of 2008-09, Threadneedle Street has publicly rejected the use of negative rates, warning that they would make banks less profitable and potentially drive some of them to the wall.
But as the Bank’s governor, Andrew Bailey, noted on Thursday, life has moved on. Banks are less vulnerable than they were a decade or so ago, other central banks, including the European Central Bank and the Bank of Japan, have used them, and estimates of how low interest rates can go have moved down. “Ten years is a long time in monetary policy,” Bailey said in a nod to Harold Wilson.
The seriousness with which negative rates are being considered can be judged by the fact that the Bank devoted four pages of its latest monetary policy report (MPR) to weighing up the pros and cons. You don’t do that if you are trying to kick the idea into the long grass.
Bailey’s response to a question about negative rates at his MPR press conference was also revealing. “This is the most extensive assessment we have ever done,” the governor said. “It is sensible to have negative interest rates in the tool box but we are not planning to use them at the moment.”
The key words there are “at the moment”. Although the economy has performed a bit more strongly than the Bank envisaged in the scenario it sketched out three months ago, it thinks the pace of recovery will slow and be more protracted. What’s more, it views the risks as being very much to the downside.
What does that mean? It means that there is no prospect of monetary policy being tightened for a very long time, as the MPR made clear. It means that there will probably be more QE as activity slows over the winter. And it means that the debate about the use of negative rates will not go away. The use of them remains a case of if not when, but markets should take note of Bailey’s warning that there are some “hard yards” ahead. What was once unthinkable is no longer so.