Deflation and negative interest rates - will they happen in the UK?

As the Government transitions the country into a ‘new normal’ through tentative re-opening of hospitality and retail from its three-month hard lockdown, we look into what the future economic landscape may look like and what it could mean for investors and savers. 

The Coronavirus pandemic not only removed the ability to spend our money but it has also reduced the employment rate despite the furlough scheme which intended to halt the severity of increasing unemployment in the UK.

All of these factors have put huge pressure on economic growth, inflation and interest rates.

Interest rates are already at record low levels but could they go further? As we look into the second half of 2020, questions are being asked about the possibility of deflation and the Bank of England (BoE) potentially implementing negative interest rates. But what will this mean for our investments and savings?

Why might we experience deflation and negative interest rates?

In response to the pandemic the Government adopted a quantitative easing (QE) programme, the expansionary monetary policy that allows central banks to pump new money into the economy to encourage UK companies to quickly rebuild their supply levels.

The demand side shock is more difficult to fix in the short term due to the ever-growing uncertainty which is looming over our heads - meaning more of us may be cautious about spending our money right now. Quantitative easing does not automatically create inflation, as the government is issuing the new money supply in return for less liquid assets.

That said the Chancellor, Rishi Sunak is using all the tools in the Government’s armoury to get us spending - from stamp duty holidays for properties worth up to £500,000 to the ‘eat out to help out’ scheme.

Inflation had fallen to a four-year low of 0.5% in May 2020 and although CPI had recovered somewhat in July to 1%, this is still significantly lower than the BoEs 2% target

As inflation is a key consideration when the Monetary Policy Committee (MPC) sets the interest rate, it could mean, in theory, that interest rates could fall below 0% in the coming months.

And in fact Andrew Bailey, the Governor of the Bank of England has already warned lenders of the challenges that could arise from this, clearly indicating the Bank is looking at all options available.

If this were to happen, it will be the first time in the BoEs 325-year history but it’s not completely unfamiliar territory as some of our European neighbours have experience of this. Switzerland enforced negative interest rates to prevent the possibility of their currency becoming too strong, so perhaps we can take some learnings at least. 

The idea behind dropping interest rates below zero is that lenders will pay you to borrow and you will be charged to save.

The reality of course may be somewhat different. But ultimately, it is an act of trying to get us to spend and borrow more to stimulate the demand that the economy is currently lacking.

Without this stimulation, the economy could fall into a deflationary spiral – in effect, an ongoing recession.

The risk involved would be that banks may be reluctant to transfer on the cost of negative interest rates to their customers because it may encourage them to remove their savings from their accounts.

The bank in this instance would take on the extra cost to protect the customer from having to pay to save. In this case, banks would have reduced profits from the extra cost they are taking on. 

If they did transfer the extra cost of negative interest rates to the customer, it would be likely that they will scare people away from ‘saving’ as ultimately, they would be losing money, not increasing their funds.

Both of these scenarios have direct pressure on banks profit levels. The less profits they generate, the less cash they have in reserve and therefore the less they have to lend. This is exactly the opposite of what the policy would be intended to do.

What will Negative interest rates mean for savers and investors? 

Cash Savings

Negative interest rates could mean that the banks and building societies would have to pay to keep money on deposit with the Bank of England, however it’s unlikely that they would charge all customers on their savings.

That said, the high street banks are already paying as little as 0.01% on easy access accounts - so there is little wiggle room to cut rates further. Could they start to charge customers on their savings – in the way that some current accounts charge a fee?

If they did this, it could be the catalyst to get loyal savers to move their money from their bank. However, the worry is that if they do withdraw their funds, they keep it stashed under the metaphorical mattress, which would create a big security risk.

Hopefully it won’t come to that though, as there are likely to still be plenty of savings providers who will be keen to continue to raise money from savings customers.

So we’d expect to see accounts still available which pay at least some interest - but it’s more likely that these will be providers that are relatively unknown.

Investments

Negative interest rates could affect investors in many ways.

We would likely see the demand for corporate and government bonds increase because they will most likely still offer a more attractive rate than banks can offer.

The influx of demand would force the bond price up meaning the yields become squeezed and therefore return less to the investor. 

When identifying how pensions will be affected, there are a few angles we can assess.

Firstly, if we were to look at defined benefits pensions then it might increase the transfer value because they are inversely related to gilts. However, there are many more complexities to consider when it comes to the value of defined benefits pension transfers. 

For those with defined contribution pensions, some may decide to increase contributions into their pensions if they aren’t getting a return from their cash deposits, as they will at least receive the tax relief. It’s always necessary to have a reserve lump sum of cash available for short term and planned expenses but when the excess cash you have in the bank isn’t performing, people may chase a different type of return. 

Ultimately, deflation and negative interest rates could make it harder to get a return on our money. The banks will have low, zero or negative rates and bond prices will rise.

These scenarios could cause people to consider increasing exposure to greater risk. But this could be a bad move.

It’s important not to make a knee-jerk reaction. Instead remember that time in the market is the most important factor but it makes sense to check that your investment portfolio is diversified and risk appropriate.

Our portfolios are carefully designed to protect on the downside and then capture the upside by diversifying well across a spectrum of assets, while matching our clients’ attitude to risk.

Please note: the value of your investments can fall as well as rise. You may not get back what you invest. Past performance is not a guide to future returns. 

Will a recession make negative interest rates more likely?

As with any economic policy, there are both positive and negative consequences to consider. Now that we are officially  in a recession, stimulus policy like negative interest rates may be taken more seriously and the probability of this being implemented rises. That said, it would be the first time in the Bank of England’s history, so it’s a move that wouldn’t be taken lightly.

If you are concerned about your investments or savings and feel you may benefit from speaking to an expert, why not get in touch. As a firm of Independent Chartered Financial Planners, we are here to help on all aspects of wealth management

We’re currently offering all of those with £100,000 or more in savings, investments and pensions the opportunity for a free pensions cash flow review worth up to £500. Do you know when you can afford to retire? It could be sooner than you think.