The Bank of England (the UK’s central bank) has raised its main interest rate once again. This is the 13th time the rate has risen in the last two years, and it will have a ripple effect across the economy.
A central bank rate rise feeds into
the rates that banks, businesses and people are charged to borrow, but it
should also boost savings rates. These rates can - and are - being affected to
different degrees, however. In central bank jargon, this is called the
transmission of monetary policy varying across markets. For instance, while
mortgage rates have rocketed in recent months, deposit rates for many savings
accounts just haven’t kept up.
Indeed, many major UK banks currently only offer a rate of around 2% interest on savings held in a standard, easy to
access account. Some accounts will pay more, of course, but savers need to
shop around and move accounts to get these rates.
Your bank typically holds some of the
savings deposited by customers like you as 'reserves' with the Bank of England.
Historically, reserves were kept with the Bank of England for regulatory
reasons - to ensure the bank has funds in case of surprisingly high
withdrawals. More recently, the main reason is that the Bank of England pays
interest on these reserves.
The interest paid to your bank on
these reserves corresponds to the 'base rate' (which is also referred to as the 'policy rate'). This is now 5% in the UK. When you deduct (for example) the 2% they pay in
interest, this means a bank could make a handsome profit margin of 3% on your
deposits. This is likely to be much higher than the marginal cost of servicing your
account.
Around 18 months ago, the Bank of England base
rate was 0.1%. And so, with deposit rates at or close to 0%, the deposit
margins banks made at this time were minimal.
But rather than passing on rate
increases made since to their depositors - as they have with loans and
mortgages - some banks have been increasing their deposit margins on certain
accounts, which generates money for their shareholders. These margins may rise
further if interest rates continue to increase.
The Bank of England typically raises
rates in order to cool down the economy and decrease inflation. Higher rates
encourage people and businesses to save more and spend less, which is what
tends to slow down inflation. But as deposit margins widen, the effects of such
monetary policy weakens. When interest rates on deposits remain low, saving is
less attractive and so people and businesses continue to spend and inflation
continues to rise.
Bringing deposit rates closer to
policy rates would strengthen this bond, reducing the overall increase in
interest rates needed to bring inflation under control. Compressing the deposit
margins that banks make is therefore in the interest of the central bank, and
of the economy in general.
Central banks should pay interest on
reserves
Many high street banks have
accumulated a large stock of reserves over the past decade as a result of
massive liquidity injections by the Bank of England during successive rounds of
quantitative easing. For example, following the 2008 global financial crisis
and then to keep the economy afloat at the height of Covid, the Bank of England
bought government and corporate bonds to stimulate the economy, thereby
boosting the amount of money in circulation.
Having used this tool multiple times
over the past decade there is now a lot of money available to banks and so they
often park any funds they do not lend out as reserves with the central bank. As
explained already, these reserves earn the base rate.
Reserves are paid by the Bank of
England, but any profit or loss it incurs actually belongs to the government -
and ultimately the taxpayer. So, if the Bank of England was to pay a low, or
zero, interest rate to high street banks instead, it would reduce the interest
the government must pay on these reserves. Admittedly, this could discourage
banks from holding more money in reserves and instead aggressively lend the
money to businesses and households. But this would be inflationary, which
defeats the purpose of rate rises.
Some former BoE officials have
suggested simply forcing the banks to hold such reserves at a 0% rate, thereby
saving the government billions in interest payments. But the Bank of England
governor, Andrew Bailey, says this would affect the central bank’s ability to
'steer the economy'. What the Bank of England needs now is for rates to
increase, not decrease, to tackle inflation. In short, such a policy would help
the government’s finances, but impair the Bank of England’s mission to tame inflation.
Banks should pass on interest to
savers
What if central banks only paid high
street banks interest for holding these reserves if they pass on rising
interest rates to savers? This policy would improve the transmission of
monetary policy, making the Bank of England’s job easier by reducing the
overall amount by which interest rates would need to rise to bring inflation
under control.
On top of improving monetary policy
this would go some way towards protecting depositors from seeing the value of
their savings eroded by inflation, alleviating the cost of living crisis.
Compressing deposit margins would reduce bank profits. But there is no
particular reason why bank shareholders - typically wealthier people that can
better absorb the rising cost of living - should receive a windfall from the
rapid increase in interest rates caused by high inflation while others suffer.
Frederic
Malherbe
Professor of Economics and Finance, University College London (UCL)
This article is republished from The Conversation under a Creative Commons license.
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