The MPC set out its collective assessment of the potential issues that a negative policy rate in the UK could raise, and how that might impact the effectiveness of negative rates as a monetary policy tool, in its August 2020 Monetary Policy Report.13 I won’t repeat all of the analysis from the Report; instead I want to draw out three key points. The first is that the effective lower bound is likely to be different across different countries, reflecting different macro-economic circumstances, structural features and financial systems. This is a simple point but an important one. Just because negative rates are appropriate in one country does not mean they would be appropriate in another, and for some countries and in some circumstances the effective lower bound may well be positive. The second point is that while some aspects of the transmission mechanism would be the same as any other rate cut, others could be quite different. In all use-cases, market interest rates would fall, asset prices would rise and the exchange rate would depreciate, and that would stimulate demand and raise inflation in the usual way. But evidence from other countries’ experience suggests that while corporate deposit rates can turn negative, household deposit rates would be unlikely to fall below zero, meaning that pass-through could be somewhat weaker than for a normal rate cut. Building on this, the third point I want to draw out is that there can be knock-on economic effects through the banking system.
UK GDP has recovered fairly rapidly in aggregate so far from its trough earlier in the year. In our August Monetary Policy Report forecasts, we projected that recovery to continue, though at a slower pace. Unemployment was projected to peak in Q4 and decline only gradually. And inflation was projected to return to target from its current low level as domestic price pressures picked up. (Figures 11-13) Those projections were conditioned on the assumption that the direct impact of Covid-19 on the economy would dissipate gradually over the forecast period, as well as on market interest rates and the monetary and fiscal policy support measures that were in place at the time. This summary is in no sense intended to downplay the unprecedented impact the virus continues to have on individuals, on particular businesses and sectors, and on different regions and nations of the UK at different times. As flagged in the MPC’s September Minutes, there is a real risk of a more persistent period of higher unemployment, and the recent strength in income growth might not be sustained. I remain particularly concerned that we could also see structural headwinds to recovery in the labour market, with particular impacts on younger workers and those joining the workforce. The negative impact on the supply side of the economy, or degree of scarring, could potentially be greater than the 1½% we have assumed to date based on very preliminary work, a risk the MPC has previously highlighted.