The narrowing options for Bank of England to act upon

Governor Carney must at some point give serious thought to negative rates

16:06 October 16, 2016

What should the Bank of England (BOE) do post Brexit? Raise interest rates versus lower interest rates?

Support a higher value for the sterling pound against other currencies versus letting the pound depreciate? Should the Bank of England expand its own quantitative easing (QE) programme and see how this will work out?

Should it induce a negative rate on bank deposits? Should it now cut bank reserve ratios, if applicable, as a much milder measure than any other that is supposed to increase money supply in the economy?

The end game for the UK should be to ensure that its exports remain competitive, especially with the EU being its main market, and that it can manage the economic uncertainty following Brexit. This also means tailoring its monetary policies towards attracting investments and promoting growth in certain economic sectors.

So, BOE did cut interest rates, which should have increased money supply in the economy. The pound depreciated as a result. Should the rate be cut further?

Recalling what other central banks have done, they did in fact go through a certain process of first cutting interest rates to near zero that it no longer worked. Then, they started their quantitative easing programme, which also worked up to a certain point with decreasing effectiveness as it was expanded.

The final step taken was the introduction of negative rates on deposits. All of the above was intended to increase money supply, with the assumption that this would neutralise any economic slowdown and ensure that the economy achieves a targeted inflation rate.

So what should it be for the BOE? The immediate consequences of Brexit were mitigated by the immediate depreciation of the pound. The later cut in interest rates made sure that the appreciation in value that followed was controlled rather than it turning into an upward trend. And that could have harmed the UK’s economy. What’s next? The dilemma here is in cutting interest rates to near zero, which leaves no wiggle room for any future interest rate cuts, leaving the BOE with the other three tactics: cutting bank reserve ratios, expanding the QE programme, and introducing negative deposit rates.

Instead, the BOE might want to consider refraining from further cuts in interest rates, for two main reasons: 1. cutting interest rates further would leave no room for further cuts if needed for whatever reason. Also, if BOE needed to raise interest rates at any point, the pain of doing so would be larger than the benefits from the previous cuts given the current economic uncertainty. 2. The relationship between interest rates and bonds should be considered by the BOE. As the UK would want to attract investments given Brexit, lower yields for relatively safer bonds will not be very encouraging. With cutting interest rates not being recommended, the remaining options are pointed out earlier are: cutting bank reserve ratios, expanding the QE programme, and introducing negative deposit rates.

The first one is not applicable as BOE abolished those as part of 1980s reforms, while keeping a cash ratio that is linked to banks’ liabilities. Between QE and negative deposit rates, the latter might be more appropriate at least in the beginning.

Negative rates would be preferable for a country that wants to increase money supply without inflating its balance sheet once QE is expanded. It’s also argued that the BOE’s QE has already reached a saturation point in terms of reducing yield on long-term bonds — the earlier cutting of interest rates lowered the yields for shorter ones.

Even if BOE decided to anyway expand its QE, the market does not seem to want to sell bonds to the government and attain cash that it would supposedly spend in the economy — private consumption that is supposed to stimulate growth. The last thought that I want to leave you with: what happens if too much money supply dilutes citizens’ purchasing power?

— The writer is a UAE-based economist. You can follow him on Twitter at @aj_alshaali.