May 20, 2020 / 3:15 PM / 16 days ago

How do negative interest rates work?

LONDON (Reuters) - Investors are pricing in the possibility the Bank of England will follow other central banks in cutting interest rates to below zero for the first time.

Over the past week several BoE officials have refused to rule out negative rates.

Britain sold a bond with a yield below 0% for the first time on Wednesday.

The European Central Bank, the Bank of Japan and others have already taken rates negative and President Donald Trump last year labelled U.S. central bankers “boneheads” for not doing so.

This is how a negative rate policy works alongside some of its potential pitfalls:

WHY HAVE SOME CENTRAL BANKS ADOPTED NEGATIVE RATES?

During the global financial crisis of 2008-09, many central banks cut interest rates close to zero.

With their economies still struggling in the years that followed, policymakers in the euro zone, Switzerland, Denmark, Sweden and Japan allowed rates to fall to slightly below 0%.

The coronavirus pandemic has now put pressure on central banks to pump even more stimulus into their economies.

The U.S. Federal Reserve, which had managed to push up borrowing costs in recent years, cut rates back to just above zero but has signalled it does not intend to go further.

The BoE cut its Bank Rate to a record low of 0.1% in March and has said it is ready to do more to help the economy, probably most immediately by buying more government bonds.

But new governor Andrew Bailey has sounded less opposed to the idea of negative rates than his predecessor Mark Carney and the BoE’s chief economist Andy Haldane said it was something being considered.

Investors are betting the BoE might go negative around the end of this year.

HOW DOES IT WORK?

Under a negative rate policy, banks and other financial institutions are required to pay interest for parking excess cash — beyond what regulators say they must keep on hand for safety reasons — securely with the central bank.

Avoiding the charges is an incentive for banks to use their money to lend more to businesses and consumers, helping growth.

The ECB introduced negative rates in 2014. Its deposit rate is currently -0.5%.

The Bank of Japan went negative in 2016, mostly to prevent a strengthening yen from hurting its export-heavy economy. The BOJ uses aggressive asset purchases to guide short-term rates to -0.1% and the long-term rate to about zero.

WHAT ARE THE PROS, CONS?

Negative central bank rates lower borrowing costs for businesses and households.

Advocates say they also help weaken a country’s currency by making it a less attractive investment than other currencies. That can give exporters a competitive advantage but boosts inflation by pushing up import costs.

But negative rates also narrow the margin that financial institutions earn from lending — something BoE officials have previously said could prove counter-productive, hurting banks and reducing the flows of credit to the economy.

The speculation about Britain comes as the ECB and the BOJ have sought to reward banks that use their credit lines, recognising the need for incentives to boost lending rather than just punishing them for parking their money.

There are also limits to how low negative rates can go — depositors can avoid being charged negative rates on their bank deposits by choosing to store banknotes instead.

Reporting by William Schomberg in London, Leika Kihara in Tokyo and Balazs Koranyi in Frankfurt

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