This is how negative interest rates work - and how they could help the economy recover

Cutting rates below 0.1 could help to boost spending and lending (Photo: Shutterstock)Cutting rates below 0.1 could help to boost spending and lending (Photo: Shutterstock)
Cutting rates below 0.1 could help to boost spending and lending (Photo: Shutterstock)

The coronavirus outbreak has not only put public health at significant risk, it has also hit the UK economy particularly hard.

Many businesses across the UK have been forced to close, or place their staff on furlough so as to save people from redundancy.

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In an effort to kick start the economy, the Bank of England governor has suggested that interest rates could be cut below zero and told MPs it would be “foolish” to rule it out.

What are negative interest rates?

Negative interest rates simply means that rates have fallen below zero per cent.

The central bank governor Andrew Bailey said he was “actively reviewing” negative interest rates as one of the options to help see the economy through the coronavirus pandemic, as cutting rates below 0.1 could help to boost spending and lending.

The move comes after the UK sold a government bond with a negative yield for the first time, meaning investors have to pay to lend money to fund the government’s response to the pandemic.

Mr Bailey, who took over from predecessor Mark Carney in March, told MPs the bank is not ruling in negative interest rates, but is keeping the outlook for how low UK rates could go under “active review”.

This includes the prospect of negative rates and the possibility of buying riskier assets under its so-called quantitative easing bond-buying programme.

Speaking at a hearing with the Treasury Select Committee, Mr Bailey said: "We do not rule things out as a matter of principle.

"That would be a foolish thing to do. But that doesn't mean we rule things in either.

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"We know that we may have to draw on our tool kit at any point, [...] having that whole tool kit under review and assessed as the context changes is important."

How could it affect mortgages?

Negative interest rates could mark good news for those with a mortgage, as it would likely result in a lower rate.

If interest rates are below zero, the bank effectively pays customers to borrow money, meaning you would be paying back less money than you have been loaned.

How can they help to boost the economy?

In theory, negative interest rates help to fight deflation by making it more costly to hold onto money, thereby encouraging people to spend more.

As such, it is less appealing for people to keep their money in the bank, as they would accrue little to no interest on their savings.

At the same time, negative rates also encourage people to borrow money, as it pushes loan rates down.

Have negative interest rates been introduced elsewhere?

The policy has been deployed by the European Central Bank and Japan, but there are concerns it has limited effectiveness in encouraging spending and investment long-term.

Policymakers are now “looking careful” at the experience of other central banks that have cut their rates to below zero.

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Mr Bailey said the Bank of England, which has already cut interest rates to 0.1 per cent to help boost the economy, believes the benefits weaken as rates approach zero, meaning such a move could be “counterproductive”.

His comments come as official figures released on Wednesday (20 May) revealed that inflation in the UK plunged to a near four-year low of 0.8 per cent in April, which was significantly lower than the Bank’s target of two per cent.