There has been much speculation recently as to whether the interest rate could become negative if the economic climate continues to worsen. Expectations of a deflationary gap in the near future have deterred an interest rate rise to quell current inflation. The aim of negative interest rates is to increase liquidity in the market creating higher demand for goods, artificially compensating for the decline in consumption. However there are questions as to whether a negative interest rate would actually have an impact on consumption and create the level of demand desired.
When someone borrows money from a bank their debt is bundled up with other borrower’s debt and packaged as a credit derivative. This product is then sold to other institutions who receive the payments the borrowers make on the debt. The risk is now held by the institution that purchased the debt enabling a lower rate of interest than the original bank alone could offer the potential borrower. When the credit crunch started in 2007/2008 packaged debt products became less desirable to purchase due to the increased risk of default created by the subprime market. As a result of the lower demand for credit products banks had to hold onto more of the debt they issued themselves, meaning the interest rate rose to compensate for the higher risk they carried. If the interest rate did not rise then less debt was offered and lending declined.
The interest rate in this circumstance changed from being led by a macroeconomic target to stimulate the economy, to being led by the risk element of the lending mechanism fuelled by the uncertainty of repayment. Even if the interest rate set by the Bank of England reduced and more funds became available to lend the return required by the banks to compensate for defaults increased. The demand for borrowing and risk of inability to make repayments in combination with the lack of demand for packaged credit products pushed up interest rates for borrowers. Even if the Bank of England base rate has reduced the actual rate of borrowing has increased in many cases.
In addition to risk element of lending and the effect on the interest rate, the actual link to the base rate is not present in all lending products. Only about half of the loans in the UK are linked to the base rate. Tracker and variable rate products follow the base rate and CAT standard mortgages (Charges, Access and Terms) have to have an interest rate within two percent of the base rate. However other banking products can have an interest rate at any level the bank is prepared to offer. Even if the borrowers with outstanding debt, which are linked to the base rate, receive a reduction in repayment costs due to an interest rate cut it does not guarantee they will spend it and increase consumption. In fact the majority of borrowers are taking advantage of the low interest rate to pay debt down.
The interest rate mechanism leading to changes in consumption no longer works due to the high levels of debt that already exist. The reduction in interest is merely providing more liquidity and not taking into consideration the problem is one of insolvency. The situation questions not only whether negative interest rates will be ineffective, but whether the interest rate mechanism as an aggregate demand control is capable of working at all anymore.
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