Interest rates have been at a record lows since the start of the coronavirus pandemic. However, there are murmurs of interest rates moving even further south, and potentially into negative territory. In this article, I’ll explore how interest rates work and why we could be headed for a negative interest rate environment, and what it could mean for us as consumers.
The role of the Bank of England
The Bank of England’s Monetary Policy Committee (MPC) is responsible for setting what’s known as the “base interest rate”. This is the rate of interest the Bank of England pays on deposits held by commercial banks, being the banks that everyday customers like you and I use.
Since March 2020, the base rate has been 0.1%. This is the benchmark that commercial banks use for setting their own saving and lending rates, and explains why we have seen such low rates of interest on offer for the past few months.
Meeting roughly every six weeks, the members of the MPC review the latest news on the UK and global economy, unemployment rates and Gross Domestic Product (GDP) growth or decline. Their task is to keep the UK economy on track to meet the inflation target of 2% set by the government.
The impact of the coronavirus pandemic on the economy has been deeply felt. Unemployment continues to rise, uncertainty around further regional and national lockdown is impacting business recovery and the economy as a whole has shrunk considerably compared with 2019, in spite of the government’s unprecedented economic bailouts. Our economy is in a recession.
In mid-October, against a backdrop of inflation at 0.7% (remember the target is 2%), the MPC asked banks and building societies how ready they would be if the base rate moved into negative territory. This was seen as a clear sign that they’re contemplating lowering rates to stimulate the economy.
How negative interest rates can stimulate the economy
If the base rate was set at negative, then commercial banks would have to pay to hold cash deposits with the central bank. Having to pay interest on deposits with the Bank of England provides a significant disincentive for banks to hold cash at the central bank, and instead encourages them to lend it out to businesses and consumers. As a result, we’d expect to see banks further lowering both their lending and savings rates.
Negative interest rates create an environment where savings are unattractive and spending’s easier - especially if banks pass through cheap rates to their loans and mortgages. If money is cheap to borrow, businesses and consumers take out loans and spend more, thereby boosting the economy.
This is the economic rationale for lowering rates into negative territory. But whilst the European Central Bank and others have already taken rates negative, this has never been tested in this country before. Whether the theory will hold during times of significant borrower risk, no one can say with any certainty.
What this could mean for those with mortgages
Average mortgage deals are now cheaper than before the pandemic, albeit the number of mortgage deals on the market have reduced substantially since March 2020.
Could mortgage rates go lower? History suggests that rate decreases tend only to be passed through to savers, while mortgage borrowers see no benefit. Whether UK lenders would follow the Danish banks in launching negative mortgage rates remains to be seen.
Regardless, for those who want to get on the mortgage ladder or re-mortgage to get a better deal, rates are some of the cheapest seen in recent times.
Importantly, for those with ‘variable rate’ or ‘tracker’ mortgages linked to the base rate who might be getting excited about getting paid to borrow money, unfortunately most of these mortgages will have a mechanism in place which stops the rate dropping below zero.
What this could this mean for savers
Banks pay you interest when the base rate is positive, but would a negative interest rate mean you have to pay your bank to hold your cash?
It’s uncertain exactly how negative interest rates charged by the Bank of England would be passed on to savers by commercial banks. Whilst those with cash savings may not be charged interest directly to keep their money in the bank, they may find charges passed through in other ways.
One possible scenario is that savers may have to pay to have a bank account, that is, pay their bank to keep their money safe for them. Earlier this month Starling Bank became the first British bank to introduce negative interest rates for personal account customers with Euro accounts. HSBC also made a statement last month that they might have to start charging for ‘basic banking services’. So whilst we might not see interest being charged directly on our savings, we could possibly see the end of ‘free banking’ as we’ve typically known it.
What’s almost certain though is that if the base rate was sub-zero, historically low bank rates would hit zero and savers would earn nothing on their deposits. With no incentive to save, they in turn are more likely to spend money on consumer goods and services.
Already rock-bottom rates over the last few months have hit savers hard, especially as many people still in employment or on furlough have been able to stash away more money whilst the lockdown restrictions have been in place. Changes brought about by negative interest rates could be the last straw; it may encourage savers to look at alternatives homes for their money rather than keeping it in the bank.
When money in the bank isn’t growing, it’s at the mercy of inflation, meaning we can buy less with the same money in the future. To hold the value of our hard-earned money, we need to at least match inflation, but ideally beat it if we want our money to grow. It’s possible that we’ll see an uptick in money flowing into the stock market as risk-aware savers seek out inflation-beating returns.
What this could mean for your pension
The impact negative interest rates could have on pensions is still relatively unknown, as it’s not been seen before. Defined benefit (also called ‘final salary’) pensions are likely to avoid any damage as they provide a guaranteed income in retirement, however, savers with defined contribution pensions could see their potential income drop.
Any drop in value is unlikely to have a lasting impact for the savers furthest from retirement, as they’ll have time to ride out the bumps and benefit from the long-term growth of their investments. But for those closer to retirement, any significant drop in value could have an impact on their retirement plans as they’ll have less time to recover any losses.
Although many pension plans adopt a lower-risk strategy for those approaching retirement, investing in assets such as bonds, if interest rates drop, or turn negative, the value of bonds would decrease. Therefore this could mean a drop in pension value for those closer to retirement.
But all of this depends on what happens next. The next meeting of the MPC is on 17 December 2020.