With interest rates at an all-time low and the economy facing uncertainty, you may have read headlines about whether negative interest rates are the next step. But what would that mean in practice and is it an option that would really be considered in the UK?
Ever since the 2008 financial crisis, interest rates have been low. Earlier this year, there were suggestions that the Bank of England would gradually start to increase its Base rate as the economy continued to recover. However, the Covid-19 pandemic has changed that. In March, the central bank decided to cut the interest rate twice in a month.
Lowering interest rates is one of the tools central banks around the world use to stimulate economic growth as it lowers the cost of borrowing. With coronavirus disrupting normal business practices, the Bank of England first cut its base rate from 0.75% to 0.25% on 11th March 2020 and then slashed it again to 0.1% on the 19th March 2020, the lowest it’s ever been.
With the interest rate hovering just above zero, the possibility of negative interest rates is rising.
You can split the impact of negative interest rates into two areas depending on whether you’re saving or borrowing.
Let’s start with saving.
Usually, when saving, you’d earn interest on the deposits. For example, with £1,000 in a savings account earning 3%, you’d receive £30 after a full year. If the interest rate is negative at -3%, you’d instead owe the bank £30, in effect paying to save your money.
Once you factor in the impact of inflation on your spending power, savings can quickly become eroded if interest rates are below zero. While using a saving account is still important in some cases, such as holding your emergency fund, it may mean that alternatives should be considered to get the most out of your money, such as investing.
Moving on to borrowing, in theory, negative interest rates are good news.
The cost of borrowing should reduce as interest rates fall. Using a mortgage as an example, you’d still need to make repayments, however, with a negative interest rate, the outstanding amount is reduced each month by more than what you’ve paid. It can reduce debt quicker. However, it’s worth noting that some mortgages have a ‘floor’ interest rate that it won’t go below.
While negative interest rates have never been implemented by the Bank of England they have been used elsewhere.
Sweden’s central bank cut interest rates to -0.25% in July 2009, in the wake of the financial crisis. Since then it’s been used by other European banks too, including the European Central Bank which covers the 19 countries that have adopted the euro, as well as Japan.
There are a variety of reasons why negative interest rates are used. However, during times of recession or economic hardship, people and businesses tend to hold on to their cash, waiting for the economy to improve. A lack of spending by businesses and individuals can weaken the economy further. As a result, negative interest rates can be used to encourage people to spend and drive the economy forward, though there are risks associated with the practice too.
While negative interest rates have been used before, they are by no means the norm and are still considered unconventional.
So, are negative interest rates coming to the UK?
It’s impossible to say for certain and much of the decision will depend on how the economy and businesses respond over the coming months. When asked about the potential for negative interest rates to be introduced in May during a Treasury Select Committee, the Bank of England’s governor Andrew Bailey said negative interest rates were under ‘active review’.
Bailey added: “We do not rule things out as a matter of principle. That would be a foolish thing to do. But can I then follow that up by saying that doesn’t mean we rule things in.”
As always, it’s important to keep an eye on your financial plan with current conditions in mind. However, responding to speculation should be avoided. Instead, if you’re concerned about the introduction of negative interest rates, keep in mind that your financial plan has been built with your goals at the centre. There may be a time when negative interest rates are announced and we’re here to help you assess your financial plan if this should happen. Please get in touch if you have any questions.
Please note: The value of your investment can go down as well as up and you may not get back the full amount you invested. Past performance is not a reliable indicator of future performance.