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Bank of England opens door to negative interest rates for first time

Bank of England Governor Andrew Bailey said for the first time that negative interest rates are a tool the bank could turn to if required as the U.K. economy takes longer to recover from the impact of the coronavirus than previously estimated.

The bank now projects GDP might return to pre-coronavirus levels by the end of 2021, having previously predicted it getting there by the second half of 2021. In its first official forecast since the pandemic struck, the bank also said the economy will be 1.5% smaller than it would have been without the pandemic.

"I think this is the first time the bank has said definitively yes they are in the tool box," Bailey said at a press conference. "We don’t have any plans to use them at the moment but they are in the tool box."

Bailey had said previously that the bank was studying the potential value of implementing negative rates. It released a significant study on the topic today, evaluating the performance of the strategy where it has been tried, particularly in the European Union.

Negative rates study

"We tentatively draw the conclusion — negative rates and their effectiveness does depend on what point of the cycle you use them," Bailey said, noting that the European Central Bank's case suggests, "they're probably more effective in an established upswing than in an established downstream."

The BoE and Federal Reserve have been far more cautious in their appraisal of negative rates than other major central banks. The ECB introduced negative rates in June 2014, with the Bank of Japan following in 2016.

"There is little incentive to rule out negative rates right now and we expect the market to stay very invested in this debate well into 2021," Chris Turner, global head of markets and regional head of research for the U.K. and central and Eastern Europe at ING, wrote in a research report.

The Bank of England's monetary policy committee maintained interest rates at 0.1% and voted unanimously to maintain the target for total purchases of government and corporate bonds at £745 billion.

The pound was trading at $1.316 as of 09:30 London time, up 0.4%.

U.K. economy impact

The U.K. economy has been hit harder by the coronavirus than many of its peers, Bailey said.

"The U.K. has a larger share of its economy devoted to those sectors of the economy, particularly service economy, that are affected by social distancing," he said.

Bank staff estimate that U.K. GDP was over 20% lower in the second quarter of 2020 than in the fourth quarter of 2019. The decline is less sharp than had been speculated in its scenario in May as government restrictions were eased quicker than had been assumed.

A faster-than-expected bounceback in spending is projected to see output grow 18% in the third quarter. Higher-frequency indicators imply that spending has recovered significantly while payments data suggest that household consumption in July was less than 10% below its level at the start of the year.

The bank was more optimistic on the outlook for unemployment. It anticipates that, while the rate will rise from 3.9% to about 7.5% by the end of the year, that is lower than the previous estimate of 9%. The bank noted that government furlough schemes have cushioned unemployment so far, but the rate is projected to rise in line with a material increase in spare capacity in the economy.

Weaker inflation

Business spending remains anemic and the bank surveys suggest investment is likely to have fallen markedly in the second quarter and remain weak amid the potential for further lockdowns.

Twelve-month Consumer Prices Index inflation increased to 0.6% in June from 0.5% in May. But inflation is supposed to drop to an average of 0.25% in the latter part of the year as low energy prices combine with a temporary cut in value-added tax, or VAT, for hospitality, holiday accommodation and attractions. As a result, the bank is keeping its options open both in regards to further quantitative easing and negative interest rates.