Z | a-zofinequality

Zero interest rate policy

The Bank of England (BoE) is mandated to achieve an annual rate of 2% of consumer price inflation. The primary tool which the BoE uses to achieve its inflation target is the Bank Rate – also referred to as the “base rate” or even just “the interest rate” – which is the interest rate that the BoE pays to commercial banks on cash reserves held with the BoE [1]. While only banks can hold reserves and receive payments at the Bank Rate, changes in the Bank Rate tend to have a knock-on effect on interest rates across the whole economy. Raising it will discourage lending at the margin and put a dampener on economic activity, while lowering it will encourage more borrowing and spending, acting as a sort of stimulus.

Since the 2008-09 financial crisis and the sluggish recovery that followed the BoE has continually undershot its inflation target and in general the growth in economic activity has been underwhelming; the coronavirus crisis has been a further major hit likely prolonging the possibility of a return to a more buoyant economy for many more years. In this macroeconomic context, the BoE quickly adopted a zero interest rate policy, cutting the Bank Rate as low as they were willing to go – to 0.5% in 2009, 0.25% in 2016 and 0.1% in 2020 – with only two small rate rises in 2017 and 2018 interrupting this until the recent rise in consumer price inflation from 2021 [2]. The intent of this was to accommodate lending as much as possible to help the economic recovery, stimulate spending and eventually bring inflation back to the 2% target. This was not really successfully and even with further unorthodox interventions like quantitative easing the economy has continued to suffer from prolonged stagnation.

Rich and poor pay different interest rates.

At a basic functional level, interest rates are the fees that lenders charge borrowers in exchange for providing a loan. One of the key factors in determining the interest rate that a lender charges is the risk of default – they may not get some or all of their money back. A borrower who is perceived as having a high risk of default will usually be charged a higher interest rate than a more reliable borrower to compensate for the increased risk of loss [3]. On that basis, the rich and wealthy can typically access credit at lower interest rates due to their greater capacity to repay. Poorer borrowers, those without substantial savings pots and/or at risk of losing their income (e.g. due to unemployment), are seen as higher-risk and so are charged higher interest rates.

A key practical tool by which the risk of lending to a particular individual is assessed is through credit scores, which directly help those who can more reliably make repayments (typically the better-off) access cheaper credit [4]. Customers cannot opt out of having their histories recorded by credit agencies and even small failures in the past, or even errors by lenders and agencies, can ruin chances of getting an important loan like a mortgage [5]. Credit scores in the United States are accused of perpetuating racial wealth inequalities, e.g. by penalising otherwise credit-worthy families simply for being from poor neighbourhoods, which are often poor due to histories of discrimination [6, 7, 8].

A fundamental irony is that poor credit scores make access to credit more expensive for precisely those individuals who can hardly afford it [9]. In theory this should discourage borrowing, but in practice with the reduction of welfare state generosity, indebtedness has arguably part-replaced welfare as a safety net for poor households [10].

Additionally, the type of credit available to poorer borrowers can be seen in exploitative payday loans which charge extremely high rates of up to 1,500% APR [11]. (Payday loans are of course supposed to be repaid quickly so a full year’s rate won’t be applied, but it still poses a risk in cases of missed payments and shows the difference in rates charged.) Rates were capped at 0.8% per day by the FCA in 2015 [12].

The situations for corporations is similar. Total debt in the UK is split roughly equally between the public sector, non-financial corporations and households, each owing about £2 trillion all told.13 Just as households and governments with greater means and records of repayment can borrow more cheaply, larger and more reputable companies can borrow at better terms than smaller and newer companies.

Just as individuals have credit scores, companies issuing bonds receive credit ratings to assess their likelihood of creditworthiness which are determined by credit ratings agencies [14]. While there are lots of ratings they are generally broken into two broad categories: “investment grade” companies are considered reliable borrowers and are able to borrow at low interest rates, their bonds often being a key part of portfolios intended to offer safe returns such as pension funds due to their reputation as a safe assets. Companies thought to have a significant risk of default are given lower ratings and designated as “high-yield” or, less politely, “junk” bonds; many speculative investors are still willing to lend them money but charge much higher interest rates to balance out the risk [15].

While changes in the Bank Rate do have an impact across markets and the economy as a whole, in general only wealthier households and large companies are able borrow at interest rates close to the Bank Rate, those with less impressive credit scores or ratings pay a premium to borrow and are kept away from low interest rates except in their savings accounts. A zero interest rate policy therefore greatly encourages wealthy actors to borrow more and possibly overleverage themselves as market signals which might prompt caution are distorted by the central bank making sure interest rates, the price of money, are as low as they can get them. By contrast, less well-off households and companies, who are the most likely to find themselves in debt trouble due to their limited means to pay it off, cannot access such low interest rates and so tend not to find relief from monetary policy.

Unelected officials at the Bank of England.

The arguably undemocratic power of the Bank of England can be criticised from left and right: part of the justification for ‘People’s QE’ is that money created by the BoE should be spent according to government direction rather than going to financial institutions at the BoE’s discretion [16]; part of the ASI’s opposition to the BoE comes from their free marketeer basis and opposition to having a body essentially engaged in central planning by setting the price and/or quantity of money in the economy [17].

Adjusting the base rate is the primary tool with which the Bank of England (and other central banks with similar mandates) try to achieve monetary/price stability [18]. Since most money is created by commercial banks lending, the base rate has affects how willing banks are to lend (create) more or less, therefore indirectly affecting the money supply.

Central bank policies to bring down interest rates, including QE at the lower bound, have inflated asset prices such as housing which has increased the wealth of the already wealthy and hindered those trying to acquire assets. The rich of course tend to have greater debts in absolute terms, though not necessarily in proportional terms; those at the greatest risk of default tend to be on low incomes, however they are also the least likely to be able to actually access low interest rates so are still cut out from the benefits of a low-rate environment.

End interest rate setting.

This would certainly be possible as, to a large extent, markets already do shape interest rates. Three broad factors, can be identified which determine interest rates: base rates, bond markets, and banks [19, 20].

The central bank sets the base rate, at which banks can borrow from the central bank itself and this typically directly affects the ‘prime rate’ which banks charge each other for overnight lending to meet reserve requirements and their most reliable customers. The base rate is hugely important, but its direct effect is limited, and the knock-on effects of base rate changes on the wider lending markets tends to take about 12-18 months to be fully realised.

This is still short-term compared to long-term loans like mortgages which are repaid over the course of decades. Long-term rates are often determined by the market for government bonds rather than the base rate. These bonds, especially in rich and stable economies like the UK and US, are typically seen as the safest investment that can be made – the risk of these governments defaulting is much lower than the risk of any particular bank, company, or individual defaulting. Hence, other long-term investments need to offer more attractive returns – higher interest rates – or else investors will simply keep the money in risk-free bonds. The markets for, and returns on, government bonds therefore affect long-term interest rates. (Hence the function of QE – with the base rate near zero central banks tried to lower long-term interest rates by buying back bonds.)

Within these constraints, however, banks do not simply offer loans at the base rate or in line with bond yields to the vast majority of customers. A variety of factors affect the actual rates banks offer to borrowers: the risk (credit score) of the borrower as discussed above; longer-term loans tend to carry higher rates as the risk of default is simply longer over more time; rates on loans like mortgages can be brought down by paying larger deposits; etc. In addition there are basic market considerations: banks compete for savers and borrowers in part according to the interest rates they offer, and look to profit by charging borrowers a higher rate than they offer savers [21].

There are a few specific ways central bank rate-setting could be abolished, including: returning rate-setting powers to politicians (who, for good or ill, are democratically accountable); end rate-setting (perhaps retain a permanently fixed base rate at which the central bank can continue to lend) and allow the central bank to continue to use tools like QE/QT to pursue monetary policy; abolish the central bank (or at least its privileged functions) entirely. Of course this would be a very controversial policy area and not all of these options may be preferable to the status quo.

Instituting a permanently fixed base rate (perhaps at zero) could be a palatable option. This would allow the financial system to proceed largely as it is, but with even less intervention as the central bank could no longer adjust rates as part of its monetary policy. That rate could still exist in order to retain the provision of central bank lending. The Adam Smith Institute (ASI) produced a report advocating for the Bank of England to adopt Quantitative Easing/Tightening (QE/QT), i.e directly adjusting the quantity of money, as its’ primary monetary policy tool, rather than trying to adjust the price of money (interest rates). The ASI in fact advocates ideally going further and abolishing the BoE entirely in favour of a ‘free banking’ system, but proposes that a shift to targeting the quantity of money rather than price would at least be a step forward [22]. Of course, the negative aspects of QE that have been identified in other entries could present a problem in this case.

The Bank of England should in any case take a bolder approach to its responsibility of regulating financial markets and institutions to promote monetary stability. In some respect the BoE and other central banks are trying to be too clever by trying to achieve the fundamental goal of financial and monetary stability through inflation targets and manipulating interest rates when they could more directly influence these matters through existing and new regulatory tools like capital requirements and lending standards. It is within the BoE’s authority to directly mandate how banks behave and lend, loosening requirements and encouraging prudent lending when stimulus is needed, strengthening standard when a more restrained approach would be wise. If the BoE put more stock into this approach it might find tweaking market signals and trying to create inflation unnecessary.

1https://www.bankofengland.co.uk/monetary-policy/the-interest-rate-bank-rate

2https://www.bankrate.com/uk/mortgages/bank-of-england-base-rate/#when-does-the-base-rate-change

3https://www.investopedia.com/terms/i/interestrate.asp

4https://matrix.berkeley.edu/research/credit-and-class

5https://www.theguardian.com/money/2017/jul/17/credit-score-angencies-break-lives-lenders-no-mortgage;

6https://www.theguardian.com/commentisfree/2015/oct/13/your-credit-score-is-racist-heres-why

7https://www.cnbc.com/2018/05/18/credit-inequality-contributes-to-the-racial-wealth-gap.html

8https://www.badcredit.org/credit-scoring-law-reinforces-inequality-thinktanks-say/

9https://sfsu-dspace.calstate.edu/bitstream/handle/10211.3/172996/AS362016ANTHH45.pdf?sequence=1

10https://blogs.lse.ac.uk/politicsandpolicy/the-uks-debt-economy-creates-new-forms-of-inequality/

11https://www.moneyadviceservice.org.uk/en/articles/payday-loans-what-you-need-to-know

12https://www.theguardian.com/money/2018/apr/14/wonga-mark-2-new-breed-of-payday-lenders-oakam