The Bank of England’s role in shaping the response to the Covid-19 crisis has been significant. Guy Foster, our Head of Research, looks for clues to what the longer-term view from Threadneedle Street might be.
Whenever a new governor of the Bank of England takes office, it is always interesting, but for Andrew Bailey taking over in mid-March as the economy was about to be put into lockdown it must have felt very much like the proverbial baptism of fire. Having responded in the immediate term to provide critical stimulus, the Bank is now thinking about how to maintain a recovery in the longer term.
Immediate steps
The Bank announced last week that it would pump another £100bn into its quantitative easing (QE) programme at the same time as announcing it was keeping interest rates at an all-time low of just 0.1%.
QE can complement low bank base rates by boosting the price of assets such as bonds and shares. If the government buys large quantities of bonds, their price tends to rise, and their yield (the annual return as a percentage of the price) goes down. Then, the theory goes, the managers of big pension and investment funds, faced with higher prices and lower returns on bonds, might then look to invest in other, riskier assets such as company shares. This then boosts equity prices, making companies and investors feel richer, which in turn can encourage more spending.
Whilst the extra £100bn still represents a stimulus for the economy, it is a smaller QE injection than the £200bn announced in March, and suggests a mild “tightening” of monetary policy.
The rationale is that the economy appears to be recovering more quickly than the Bank initially thought, and so needs less stimulus from the Bank. One member of the Monetary Policy Committee, Andy Haldane, actually voted against any extra QE at all.
Where next for QE and interest rates?
Following the decision, Bank of England governor Andrew Bailey said in a column for Bloomberg that, when the economy recovers sufficiently, he would prefer to cut back its QE programme before raising interest rates.
This is an important statement for a number of reasons. Firstly, because it means that as soon as the economy is strong enough, he will look to cut the amount of government and corporate bonds that the Bank buys, which is likely to mean the price of these assets will fall.
This process is known as “quantitative tightening” and is fraught with problems. It was tried in the US and then abandoned when global stock markets fell in late 2018. Some say just as QE can boost economies, it can have the opposite effect when it is withdrawn.
Secondly, this suggests that interest rates are likely to stay lower for longer; forecasters expect the base rate to stay at just 0.1% for another three or four years. The interest rate implied by where UK government bonds are trading suggests rates of less than 0.1% for the next seven years.
Whilst bad news for savers, the certainty of low interest rates for the next couple of years allows people to budget for debt repayments, and may encourage more spending and investment.
Low interest rates make borrowing more attractive for households and businesses, and that in turn can stimulate spending. It may encourage homeowners to take on extra debt for home improvements, for example. Or simply by having a low rate on their mortgage, it can free up more disposable income for spending on discretionary items, giving the economy a boost in the process. Similarly, low rates can encourage businesses to take on more debt and use it to expand their operations, hire more staff or invest in research and development.
However, given the lack of clarity surrounding the economic recovery and ongoing possibility of a second wave of Covid-19, it is far from certain that the Bank will be able to scale back its QE programme as quickly as it might like; it may well need to increase asset-purchases again if the economy deteriorates.
Negative interest rates
Another part of the Bank’s “toolkit” for stimulating growth, is the possibility of negative interest rates, which Bailey revealed the Bank was still “actively reviewing”.
At its simplest, the idea is to discourage saving and encourage lending and spending. Under a negative-rate regime, commercial banks have to pay the central bank for holding their reserves, instead of earning interest on their reserves as is usually the case.
The most often-cited rationale is that this would encourage banks to lend in order to avoid the extra cost of storing their reserves, but there are reasons to question this logic.
Firstly, and most importantly, banks can’t and don’t lend from reserves. Reserves are for funding deposit withdrawals and settling interbank payments.
Secondly, the quantity of reserves has little or no impact on lending decisions. The decision about whether to advance a loan depends not on the quantity of reserves, but on the commercial opportunity available to the bank.
Nonetheless, they remain under consideration, and would be a genuinely novel approach to take.
Implications for savers and investors
The first point to make is that negative rates are very unlikely to be applied to ordinary savings accounts. The reason is that if customers saw they were losing money, they would most likely withdraw their savings and keep the cash at home, or find a better-paying bank.
However, it is likely that if the UK base rate turns negative, saving rates, which already average below 1% on instant access accounts, will fall further towards zero, but not below, as banks try to offset the added cost of holding their reserves with the Bank of England.
Nonetheless, negative interest rates do inevitably mean ultra-low rates on bank deposits, which is of course bad news for savers. As a result, more savers could be encouraged to seek a better return by investing in equities, thereby pushing prices up.
So, while negative rates are a sign that the economy is in trouble, they could also end up boosting share prices. From an investor’s perspective, a step that would boost business confidence and encourage savers to invest would be a positive thing. The question, of course, is would it work? Either way, it demonstrates the way the Bank is thinking about the longer-term recovery, and how best to support wider growth.
Over the long term the savings vehicles available in the UK are seeing their prospective returns drop over the years. Returns on cash and bonds are both almost certain to fail to offset the erosion of value that comes from inflation. These assets still have an important role to play as ballast within a portfolio which can be drawn upon when markets fall and present buying opportunities. However, the main burden of savings growth now rests firmly on the equity market.