Charles Goodhart, LSE professor of banking and finance
Inflation has peaked and the UK is entering a recession. Commodity prices have fallen sharply. City bonus payments are being slashed. Rising unemployment is cutting back on wage demands. And house prices are dropping rapidly.
Against this backdrop, interest rates will now fall far and fast, though the
pace of decline must be controlled to try to stop a disorderly collapse of sterling, which could push rates up again.
But how far can they drop? They cannot fall below zero, or everyone would move into cash, but they could reach zero if the recession gets bad enough and the UK suffers deflation. This happened in Japan in the late 1990s, and it ran a Zero Interest Rate Policy (ZIRP) for several years. Who knows whether recession and deflation will be bad enough to make the UK adopt a ZIRP; I certainly do not.
More important is whether, if the MPC set a zero rate, monetary policy would have shot its bolt. The answer is No. Even if the MPC should reach the zero lower bound for nominal short-term interest rates—typically close to zero—it still has the power for expansionary monetary easing.
A central bank can buy anything in its open-market operations. By aggressive purchases a central bank can expand the money stock and reliquefy the economy. When the Bank of Japan eased monetary policy, it largely bought Japanese Government Bonds (JGBs) from banks,
a minimal rise in liquidity. Even so, it became for a time the country's most profitable business. With a more aggressive policy of buying other assets—such as longer-dated government bonds from non-banks—a flexible central bank should be able to prevent deflation, whether or not a near zero rate is set.
Stephen Gallo, head of market analysis, Schneider Foreign Exchange
The case for zero rates assumes a degree of impending deflation, but a long period of falling consumer prices paired with a recession is not necessarily on the cards. Supporters of a zero rate like to compare this crisis with the fallout from Japan's asset price bubble during the 1990s. But to burst that bubble, the Bank of Japan tightened aggressively as asset prices kept rising and the yen soared—a recipe for a deflationary spiral.
In contrast, the Bank of England has been easing policy and erecting a wall of liquidity as stock and property prices have plummeted and the pound has declined. Moreover, growth in headline inflation was averaging just 1.6 per cent in Japan, against 4.5 per cent today in Britain. It is important not to confuse economic stagnation with deflation.
If anything, the enormous amount of liquidity that has been made available will prove inflationary when housing sector activity stabilises and the interbank market begins to function smoothly again. This is because the major symptom of the credit crisis has been the supply of funds not the cost of them. Reversing from a zero interest rate while mopping up this excess supply could trigger the largest double-dip, stagflationary economic contraction in history just as the current slowdown is bottoming out.
When banks lose confidence in each other, zero rates can also wipe out the interbank market, force the Bank of England to be the lender of first resort and further restrict the supply of credit to businesses and households. Money funds would struggle to cover their operating costs and Britons would have little incentive to set money aside at a time when the economy must rebalance away from debt toward savings.
Most important, zero rates will not revive the flow of credit. The Bank of England still does not have a method for restoring trust between banks, but they should soon find one.