Negative rates might tackle the liquidity trap but they are unlikely to be introduced, says Tim Harford
‘In evidence to the Commons Treasury committee, Paul Tucker [deputy governor of the Bank of England] raised the possibility of imposing negative interest rates on a portion of banking reserves, effectively charging banks rent to hold money at the BoE, but stressed that any action was not imminent.’
FT.com, February 26
It’s about time the banks got a taste of their own medicine. They’ve been borrowing my money and charging me for the privilege, one way or another, for years.
Oh, stop moaning. This isn’t the Parable of the Horrid Banker. Mr Tucker has floated this idea – very hypothetically, I should add – not because it would punish the banks but because it might encourage them to lend money to the likes of you and me. The BoE has been creating money enthusiastically with the hope that people may spend it. Yet nervous bankers have undone much of this effort because they are hesitant to lend. Negative interest rates on the reserves held at the BoE could nudge them into expanding their ambitions.
Ultimately, then, this is all about getting lending and spending going again. Wasn’t that what quantitative easing was all about? What’s wrong with the economy if printing squillions of pounds can’t persuade people to spend?
It is awkward, I agree. But it’s not entirely unexpected. There’s this thing called a “liquidity trap”, which sounds like the sort of thing that a Bond villain would unveil in a monologue but instead describes the situation where people (or companies, or banks) would rather stick their cash under a mattress than spend it. If the central bank prints money and hands it out we just sock that cash away too.
Surely a central bank with the ability to create infinite quantities of money should be able to do something about that?
That seems right, and we’re not in a pure liquidity trap: people will spend money. They just need a lot of prodding. The BoE has created about £6,000 a person and spent it on UK government bonds. There is surely some amount of money – £60,000 a person? £60m? £60bn? – at which people will be tempted to spend, or someone in whose pocket the money will burn a hole.
And then inflation will take off.
It might, but the thinking is that before it does, inventories will fly off the shelves, laid-off workers will find jobs again and the economy will recover. And at that point the BoE can hoover up the cash again, as long as it hasn’t done something silly such as write off all that government debt.
But printing literally trillions of pounds might be difficult to undo – is this why there’s this talk of negative interest rates instead?
Yes. If the economy is in some kind of liquidity trap, or slowed down by a few liquidity potholes, then the bank might look for more elegant ways to get people spending than what Ben Bernanke, the US Federal Reserve chairman, once approvingly called “the logic of the printing press”. Negative interest rates on bank reserves are one approach. Another is to threaten that even if inflation is difficult to produce, once the BoE has found some at the back of the kitchen cupboard, the British public will get that inflation good and hard for years to come.
Why on earth would a central bank want to promise to create inflation?
It’s that liquidity trap thing again. If the economy is in a slump, then people may hold on to whatever cash they can lay their hands on and this behaviour will simply prolong the slump. But if the BoE threatens to create enough inflation to evaporate our savings, and if we believe the threat, then we will spend money and that should get the economy moving again.
So why doesn’t the BoE threaten a decade of double-digit inflation?
The Monetary Policy Committee has a mandate to hit an inflation target, so such promises are probably illegal. George Osborne may in private be urging the MPC to create inflation, but the chancellor has not dared to change the inflation target. And without a change in mandate, central bankers who threaten to create inflation are like soft parents who threaten to withhold TV time. Nobody believes a word of it and so the threat has no effect. Central bankers are reduced instead to musing idly about ideas that won’t happen – such as introducing negative interest rates.
Also published at ft.com.