With the past decade have driven the base rate to just above zero, and now the Bank is debating whether to follow the example of the eurozone, Japan and several other countries in setting a negative interest rate.
What can we learn from the experience of these countries? The European Central Bank (ECB) is the most obvious comparator for the Bank of England. It moved gingerly in setting negative interest rates and suggested several times that it would go no further. But over six years, it has brought its policy rate bit by bit to -0.5%. There is no clear reason why the Bank of England could not do the same.
Retail deposit rates will not go negative On the whole, negative policy rates have been passed through reasonably efficiently to bond yields, bank lending rates and interest rates for large deposits, especially from companies. But no bank has sought to impose negative rates on regular retail deposits, for the simple reason that retail depositors would not accept it.
It is very important to tailor negative rate policy to each country's financial sector Because negative interest rates reduce the interest rate on banks' assets, but not on their retail deposit liabilities, the policy will tend to compress banks' margins. In principle, that could make banks more wary of extending credit and perversely lead to a tightening of financial conditions. In practice, it is not so clear cut, because easy monetary policy will also help banks in other ways, such as by reducing their credit losses. In the UK, these concerns apply in particular to the deposit-funded building society sector. A few examples can illustrate the importance of financial sector considerations. Japan adopted slightly negative interest rates in 2016, but the immediate sharp fall in Japanese bank equity prices called into question how much further the Bank of Japan could extend the policy, and indeed it has not reduced rates further since then.
In the US, the Federal Reserve has so far been adamantly against negative rates, partly on concerns that it would undermine the $4trn US money fund sector. As the ECB has pushed further into negative rate territory, it has coupled the shift with measures to soften the blow for banks, including allowing them to borrow at interest rates as low as -1%.
Bond yields can go much further than you think. The ECB moved to negative rates for the first time in June 2014. From then to year end, Eurozone government bonds returned 7%. In the end, low yields mean low returns. But returns can be high in the period when investors reappraise just how far negative rate policy can go. Right now, every UK gilt maturing in the next seven years has a negative yield. In Germany and Switzerland, every single government bond has a negative yield.
Investors will do a lot to escape negative yields. Some investors are unable to buy bonds with negative yields and many others will go to great lengths to avoid negative yields. That means extending into longer-maturity bonds, and shifting into corporate credit, alternative assets like real estate and foreign currency assets.
Negative rates are controversial, and that matters. One of the reasons cited by Sweden's Riksbank when it reversed its negative rate policy last year was that the policy was often seen as unnatural. Having a policy that is hard to explain and feels intuitively wrong to many people is challenging for central banks, especially when they are already being taken to task for increasing wealth inequality through their asset purchases. The frequent controversy over negative rates in Germany is likely one reason why the ECB hasn't reduced rates even further.
The Bank of England's policy review will probably conclude by year end that a negative interest rate is possible in the UK, so long as there are measures to reinforce the pass-through via the banking sector, such as an expansion of the Term Funding Scheme of cheap lending to banks. That doesn't mean an immediate move to negative rates, not least because the Bank will want to give the financial system time to prepare.
Announcing that the lower bound was now negative would already have a powerful effect, by forcing markets to price a greater possibility of negative rates in the UK.