Contemporary soundbites emerging from members of the Monetary Policy Committee (MPC) seem to suggest that, for the first time in its history, the Bank of England is considering the prospect of deploying negative interest rates as part of its policy arsenal to mitigate the debilitating economic damage likely to be unleashed by coronavirus. In a recent interview with a City newspaper, the governor of the Bank of England, Andrew Bailey, has warned lenders of the challenges that negative interest rates are likely to impose. In an official communication to the industry, he clearly enunciated that adapting to a move into negative territory would be a 'significant operational undertaking for firms?. The governor said that many firms would need a year to alter computer systems, update contracts specific for an environment of positive rates and reconsider how to communicate with clients. The letter and the musings of the governor, coupled with the historic occurrence of the three-year UK bond being auctioned at negative yields with sustained demand despite increased issuance, are stark indicators of a strong possibility of a shift into negative rate territory for the first time in the Bank's 325-year history.

Theoretical Underpinnings

Both theoretically and empirically, there is widespread ambivalence in academic circles on the efficacy of monetary policy below the Zero Lower Bound (ZLB) to generate the desired expansionary effect on the economy. Although central banks control the nominal interest rate, the real interest rate (nominal rates less expected inflation) is what drives investment and consumption. For example, households are more likely to spend today if the cost of borrowing a pound falls (that is, if the nominal rate declines), or if they think an item will be more expensive in the future (that is, if their inflation expectations rise), all things being equal. Consequently, the successful transmission mechanism of monetary policy through negative interest rate policy (NIRP) is contingent on inflation expectations increasing in tandem with a reduction in nominal interest rates below the ZLB.

Global Experience

Over the last decade, several countries have pursued NIRPs reducing their nominal rates below zero up to varying degrees. Given the limited experience with NIRP however, it is difficult to ascertain where the true lower bound lies. Theoretically, interest rates could drop as deep into negative territory as policymakers wish but in practice Switzerland and Denmark are the only two European economies to have cut their policy rates to minus 0.75 per cent, which is well below other economies pursuing similar NIRPs. The success of NIRP is inextricably linked to a subsequent upward revision of inflation expectations accommodating a meaningful drop in real interest rates thereby stimulating consumption, investment and growth. However, evidence suggests that inflation expectations have actually declined following the introduction of negative rates in the EU, Denmark and Japan, thereby dampening the impact of the monetary policy transmission. Sweden, perhaps the only outlier in the EU, has witnessed an increase in inflation expectations post NIRP. This has facilitated an amplified reduction in real interest rates, successfully achieving monetary policy transmission to stimulate growth and realise inflation target.

Japan is a particularly interesting case study in NIRP because it has effectively been in a liquidity trap since 1996, with policy rates approaching zero and now below it. There is a plethora of economic literature suggesting that if a recession is caused by an expectations-driven liquidity trap, negative interest rates are almost certainly contractionary and decrease inflation expectations even further. However, academic opinion is still split, with advocates of NIRP suggesting that negative rates were fundamental in mitigating the economic and financial woes post-financial crisis, especially in the EU.