The idea of positive interest rates is fairly straightforward to understand. If you go down to your local bank and deposit £1,000 in a savings account and it offers you a 1.8% interest rate, then you can expect to collect £18 in 12 months’ time in addition to your original deposit (although your real returns will likely be worn down by inflation of, say, 2% of more). The concept of negative interest rates, however, is highly confusing to many people and the implications for their financial plan are not immediately clear. Yet negative rates have been introduced in some developed countries, and it’s the purpose of this article to explore what this might mean for you if the UK adopted a similar model from its central bank.
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What are negative interest rates?
Until 2009 the idea of negative interest rates was exactly that – an idea. Economists could speak of it much as scientists could discuss faster-than-light travel; an interesting concept which likely could not be actualised. Yet in 2009, Sweden’s central Riksbank made the unprecedented move on the 2nd July to introduce a rate of -0.25%. The main reason for doing so was to reverse the economic decline since the 2008-9 financial crisis and reinvigorate a stagnant economy. In its wake, other central banks soon followed suit including those in Japan, Switzerland, Denmark and even the European Central Bank (ECB).
This might make you think that, overnight, regular savings accounts in these countries suddenly offered a -0.25% interest rate to ordinary consumers. Yet this isn’t exactly what happened. Quite often, what happened was that commercial banks still offered customers a positive rate, yet also required the latter to pay a small fee to hold the account (often disguised with certain benefits such as discounts at partnered restaurant chains). What was the big reason for these negative rates? In short, it was intended to motivate people to spend money. After all, if it is costing you more to keep money in a savings account, why not just go and spend it? From a government’s perspective this can be a good thing, since it promotes the consumer spending which is usually needed to help an economy through a recession. This is boosted further by the fact that it also becomes cheaper to borrow money, leading more people to buy things using credit cards.
How might negative rates affect a financial plan?
So far, negative interest rates might sound like a quirky economic experiment which turned out to work quite well where it was tried. Yet there can be adverse implications. Firstly, whilst a 0% or negative base rate can make it cheaper to get a mortgage on a house, for instance, it can also start to drive up prices (inflation). In the housing market, properties could become more expensive since more consumers are able to borrow money and bid against one another. A rise in inflation can have a significant impact on a financial plan.
For investors, higher inflation usually translates into a lower rate of real returns. For example, suppose you have a portfolio which has returned an average of 6% in recent years (after fees), which produces a 4% real return after you take a 2% rate of inflation into account. If inflation should rise to 4% (perhaps partly due to negative interest rates), then your real returns shrink to 2%. At the same time, lower interest rates are passed on by commercial banks to the customer (e.g. through an account fee) which also hurts savers. If this incentivises an individual to spend too much money (since they see little benefit holding onto it), then it could lead to their emergency savings becoming dangerously low or even depleted. In such a scenario, this person could then be at significant financial risk if they suddenly lost their job or needed to make a large unexpected expense (e.g. a replacement boiler).
The likelihood of negative interest rates coming to the UK, of course, is uncertain. One of the features of recent recessions has been that central banks have typically needed a buffer of about 5% so interest rates can be lowered if required to stimulate the economy. With the base rate currently set at 0.10%, this doesn’t leave much room for manoeuvre. As such, interest rates could possibly rise in the years ahead as the UK gradually recovers from the disruption caused by Covid-19 (and also possibly a no-deal Brexit). Sadly, only time will tell. Yet it pays to speak to a professional financial adviser about how to prepare for different outcomes in this respect, so that your financial stability and growth are not unnecessarily put at risk.
Invitation
If you want to start a conversation about your financial plan and investment strategy, then we would love to hear from you. Get in touch with your Financial Planner here at Vesta Wealth in Cumbria, Teesside and across the North of England.
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This content is for information purposes only. It should not be taken as financial or investment advice. To receive personalised, regulated financial advice regarding your affairs please consult your Financial Planner here at Vesta Wealth in Cumbria, Teesside and across the North of England.