What would negative interest rates mean for savers?

The concept of negative interest rates may sound bizarre. Still, the Bank of England continues to hold the base rate at 0.1% and previously warned banks to prepare for negative interest rates in 2020.

The Bank of England Base Rate – also called just the Bank Rate or Base Rate – has been held at a historic low of 0.1% since 2020 and is not expected to change soon.

The Bank of England’s Monetary Policy Committee (MPC) warned of possible negative interest many months ago. While this does not yet seem imminent, it’s only sensible to consider what would happen if negative interest rates became a reality.

To think that interest rates are already 0.1% is quite remarkable, given that before the 2009 Financial Crisis, interest rates were sitting between 4% and 6%.

But what this gave to savers it took away from borrowers. Those borrowing after the financial crisis discovered their mortgage rates were much better than expected. There are always winners and losers – this is intrinsic to how interest rates interact with saving and borrowing.

Today, the world economy has slowed beyond what could have been predicted even after the Financial Crisis. So it looks like 0.1% interest rates are here to stay, but can they drop further still? And what would negative interest rates mean for savers?

The Bank of England interest rate: a quick rundown

The Bank of England pays interest rates to commercial banks. This helps regulate the economy – if the Base Rate goes up, then banks will follow with their own interest rates, and the inverse happens when the interest rates fall.

The Base Rate is used to help the government maintain its 2% inflation target.

As well as controlling inflation, interest rates influence two key economic activities:

Lending
Saving

When interest rates go up, banks pay more interest to savers to hold their money. This increases the cost of lending as the interest rates on loans are higher.

Rising interest rates are designed to increase saving and keep prices low. When interest rates are higher, more people want to save their money rather than spend it.

Lowering interest rates makes borrowing cheaper, which is designed to stimulate borrowing and spending, thus increasing prices and spurring inflation when it is lower than 2% (in the UK at least).

Of course, in reality, these relationships are not always predictable and linear. There are consequences to increasing or decreasing interest rates, some of which economists are familiar with, some of which still come as a surprise.

Why are interest rates so low?

Interest rates have hit sustained record lows in the UK, the Eurozone, Australia, and Japan.

Central banks have had to open themselves up, allowing businesses and governments to access enhanced borrowing to prevent the economy from grinding to a halt.

However, falling interest rates are part of a longer-term trend driven by various environmental, socioeconomic and sociocultural factors. For example, as Investment Week highlights, our ageing populations and the number of people looking to invest in bonds for retirement, such as annuities, have created a longer-term low-interest-rate environment.

Additionally, the volatile commodities market combined with the internet – and the ability to select from a vast range of discounted goods – has suppressed increases in prices naturally, leading to low inflation.

If inflation sits below the government target of 2%, then the Bank of England will keep interest rates low until spending and growth raises inflation. In reality, interest rates are at the limits of their power. Overarching factors mean interest rates are likely to remain low for a very long time indeed.

Add to this the Global Financial Crisis and Covid-19, and you have a strange economic melting pot that has created universally low-interest rates, encouraging borrowing and spending to boost the economy and raise prices – or at least that’s the aim!

Higher unemployment during the pandemic has thrown an additional spanner in the works. Despite inflation rising with the predicted post-Covid boom, economists expect this to be transient, and the long term outlook remains bleak.

That means continued low interest rates or even negative interest rates.

Negative interest rates: why are they necessary?

Negative interest rates are not new; Sweden, Switzerland, Japan and the Eurozone have all experienced negative interest rates.

In theory, banks or building societies would charge you to save your money in a negative interest rate environment. Those with a mortgage could even earn interest!

This might seem bizarre. After all, being paid to take out a loan is an alien concept to most! Plus, interest rates are already very low, with most lenders offering high loan-to-value, low-interest mortgages already.

But, since mortgages charge interest on top of the base rate, say 2%, negative interest rates would only reduce this marginally. A tracker mortgage with a 2% interest rate combined with a -0.25% base rate would charge 1.75% to lenders, in theory.

Lenders would likely take tracker mortgages off the market if interest rates went negative.

However, what borrowers gain, savers lose. Negative interest rates will slow saving to an all-time low, making it more difficult for investors and savers to outpace inflation.

Right now, inflation is already winning the race with interest rates. Negative interest rates could be the final nail in the coffin.

Negative interest rates and saving: a licence to lose?

So would banks really charge interest on savings? Previous experience in European countries says probably not, at least not for lower-level savers.

Christina Nyman, the chief economist at Handelsbanken, told the BBC that charging interest to save money in bank accounts is “taboo” in Sweden. Nyman explained, “Competition is fierce, and households are ready to move their money to another bank, so nobody wants to lose business.”

Nyman also explained how negative interest rates could trigger people to withdraw their money ‘and stash it under the mattress’ or make alternative investments in assets like cryptocurrency. Such a scenario would leave banks short on liquidity and decrease their profitability. Such a scenario is not in the interests of commercial banks nor the Bank of England!

In Switzerland and Germany, banks only impose negative interest rates on large deposits – over 2 million Swiss Francs in Switzerland. This has led some savers to stash their money in vaults as gold! This Is Money highlights how gold has enhanced appeal for savers in this ultra-low or potentially negative interest rate environment.

Some predict negative interest rates in the UK will trigger more banks to charge monthly fees for account usage.

Sarah Coles, a personal finance analyst at Hargreaves Lansdown, told The Times that building societies and banks could introduce fees in the event of negative interest rates. Coles said, “UK consumers are hugely resistant to current account charges – customers simply don’t like the idea of paying a bank for holding their money – so they’re likely to try to avoid them.

“However, if you have an account offering a reasonable level of interest on cash, you can expect this to go.”

In our hyper-competitive economy, people will likely be highly averse to paying bank charges on their deposits. So the likelihood is that banks will find a way to avoid losing customers in this way.

Negative interest rates and bonds

Asset managers use government bonds and cash to reduce the risk of their portfolios. Bonds are a traditionally reliable savings instrument with regular interest payments and guaranteed maturity payout. However, bonds are subject to interest rate sensitivity, that is, the risk posed by fluctuating interest rates. But now, bonds are subject to much greater risk from inflation, too.

Before the current ultra-low interest rate environment, a bond yield would typically remain higher than inflation. As such, the value would rise at a quicker rate than its purchasing power falls via inflation. Thus, the bond payments provide income that more-than-compensates for a fall in the value of the bond.

But now, since inflation and interest rates are low, cash or government bonds make a loss.

The purchasing power of the bond is reducing faster via inflation than is compensated by interest payments.

This is a significant consideration for asset managers and savers researching bonds over fixed-rate savings accounts. They will have to consider how other investment options would perform and whether it’s worth locking their money away for any reasonable period considering the low maturity payoff.

What do I do as a saver?

All savers can do is keep their ears to the ground for the best savings products.

Anna Bowes, the co-founder of Savings Champion, told The Times, “There will always be competition so there will always be options. It will be up to savers to search for the best rate possible, quickly move to a fixed-rate savings account or consider other options like Premium Bonds.”

This Is Money highlights how shrewd investors can target investment funds that benefit from negative interest rates, essentially allowing savers to fight fire with fire. Namely, ‘growth stocks’ and industry disruptors could benefit from the ultra-low-cost lending environment created by negative interest rates.

It’s worth pointing out that just because interest rates are technically positive right doesn’t mean that savers shouldn’t be on the hunt for the best savings products.