On 'Digital Currencies Pave Way for Deeply Negative Interest Rates' by James Mackintosh
Even though the monetary policy talk right now is all about when the Fed will reduce asset purchases and then raise interest rates, the development of central bank digital currency has brought negative interest rate policy into the news. In his September 8, 2021 Wall Street Journal article, James Mackintosh writes that “Digital Currencies Pave Way for Deeply Negative Interest Rates.”
James defines central bank digital currencies this way:
… central bank-issued money usable by you and me, just as bank notes are. It might (or might not) pay interest, but it is different to money in an ordinary bank account, which is created by the commercial bank; the existing central-bank digital money, known as reserves, are used only to settle debts between banks and certain other institutions, not available for ordinary use.
James proceeds with a common misconception: that getting rid of paper currency is the only way to get paper currency out of the way of deep negative interest rates:
The main monetary power of the digital dollar comes from the abolition of bank notes. If people can’t hoard physical money, it becomes much easier to cut interest rates far below zero; otherwise the zero rate on bank notes stuffed under the mattress looks attractive. And if interest rates can go far below zero, monetary policy is suddenly much more powerful and better suited to tackle deflation.
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The main limit is that deeply negative rates would encourage people to switch to bank notes to “earn” zero on their savings, instead of losing money. There are costs to hoarding large amounts of physical money, including storage and insurance against fire or theft, which allows slightly negative rates. But go deep enough, and negative rates would be applied to an ever-shrinking pool of savings, undermining their efficacy and draining the banks.
I’ve written a lot—the most important pieces coauthored with Ruchir Agarwal—about how to keep paper currency around, but modify paper currency policy in ways that get paper currency out of the way of deep negative rates. See my bibliographic post “How and Why to Eliminate the Zero Lower Bound: A Reader’s Guide.”
In addition to the paper currency problem, there are two other problems for negative interest rate policy: the bank profits problem, which is also easy to solve (see “Responding to Negative Coverage of Negative Rates in the Financial Times”), and the political problem, which is more difficult. James has this to say about the political problem:
Deeply negative rates won’t come straight away. Initially, central-bank digital currencies will almost certainly be designed to behave as much like ordinary bank notes as possible, to make their adoption easy and minimize disruption, while use of physical cash will be allowed to wither away. But those close to the development agree that monetary caution is unlikely to last.
On the other hand:
… what once seemed to be an impossibly extreme monetary policy can quickly become the norm.
James argues that central bank digital currency will reduce trouble from the paper currency problem and from psychological attachment to paper currency, and that the development of central bank digital currency is well under way:
How long it takes is up for debate, but some countries have already moved beyond the experimental stage, and policy makers are feeling the pressure from crypto developers, especially so-called stablecoins tied to the value of ordinary currency.
Even though several central banks have gone to negative rates and have already braved substantial political flak, fears of the paper currency problem and the bank profits problem have kept central banks from going beyond mild negative rates. Confidence in solutions to the paper currency problem and the bank profits problem—which I have argued at length is a well-justified confidence—could lead to use of much deeper rates. As James writes:
The ECB has a rate of -0.5%, the Bank of Japan -0.1% and the Swiss National Bank -0.75%. But none think they can go below -1%.
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The monetary impact of removing, or at least reducing, this effective lower bound, as economists call it, is profound. Instead of turning to new and still unproven tools like the bond-buying of quantitative easing, central banks would be able to keep cutting rates when a crisis hit. And they would cut a long way …
What does all of this mean for investors—and in particular for yields on 30-year bonds whose term might include a negative interest rate period? James makes the good point that, while holding the size of positive rates fixed, negative rates would reduce average short-term rates and so lower the 30-year rate, that the size of positive rates wouldn’t stay fixed. When the economy does better, interest rates tend to be higher:
If negative rates worked, it might not mean a lower average over time. Instead, it might mean higher average inflation, and similar or even higher rates, as the economy could quickly be jerked out of the rut of secular stagnation, and rates and inflation return to normal.
Quite importantly, that means that negative interest rate policy is good for savers. By definition, it will reduce the interest rates they get at some points in time, but it can raise the average interest rate they get over time.
But what does James mean by his proviso “If negative rates worked”? There is, these days a strange notion abroad in the land that interest rate cuts don’t stimulate the economy. There is also another strange notion abroad in the land that stimulating the economy—even stimulating the economy a lot—isn’t likely to cause extra inflation. Both of these notions are false. Interest rate cuts do stimulate the economy and inflation does gradually rise when the economy is overstimulated. These are far from the only things that affect the GDP and inflation, but they do affect them in extremely important ways.
On why interest rate cuts are going to stimulate the economy, see “How the Nature of the Transmission Mechanism from Rate Cuts Guarantees that Negative Rates have Unlimited Firepower,” which is really about the power of any type of interest rate cut, even in the positive region.
Right now the pandemic is making it hard to read what is happening to long-run inflation tendencies, but we might well be headed toward an experiment after the worst of the pandemic is over with an overstimulated economy. So we might be headed for another data point backing up the idea that an overstimulated economy leads to gradually rising underlying inflation, where “underlying” means beyond transitory factors.
In any case, it matters whether you believe that interest rate cuts stimulate the economy. James writes:
Making a decision comes down to how you view monetary policy. If you think it doesn’t really work as stimulus anyway, then negative rates would provide little to no extra support; a Japanified economy with even more negative rates might just have lower bond yields, and still no inflation.
If you agree with the central banks that interest rates are a powerful tool for reflating the economy, then digital money removes the asymmetry that prevents rates being used to tackle deflation. That should remove much of the risk of persistent deflation, justifying higher long-term bond yields.
But there is one other big factor that could affect long-term Treasury-bond rates: the effect negative interest rate policy could have on the inflation targets that central banks set. I write about that in “The Costs and Benefits of Repealing the Zero Lower Bound...and Then Lowering the Long-Run Inflation Target.” The main reason that major central banks have an inflation target above zero is that higher inflation with the same interest rate can get some of the same stimulative effects as a lower interest rate with the same inflation. If you can use deep negative rates, there is no longer the need to use inflation as a substitute for negative interest rates.
My prediction is that if central banks become comfortable with negative interest rate policy, then inflation targets will tend to come down gradually over time. That will in turn tend to reduce the average level of interest rates. Those who have locked in a stream of coupons with a 30-year Treasury bond will be sitting on something very valuable if inflation and so available interest rates come down.
I am glad to see talk of negative interest rate policy in the news. Some of the political cost of negative interest rate policy is because it seems strange and unfamiliar. The more we talk about it, the more familiar it will seem, and the less people will irrationally fear negative interest rates—or to believe fallacious arguments against negative interest rates from those who militate against negative rates out of narrow self-interest. And anything that reduces the political cost of negative interest rates is a good thing because negative interest rates can let us avoid a repeat of the Great Recession. On that, see “America's Big Monetary Policy Mistake: How Negative Interest Rates Could Have Stopped the Great Recession in Its Tracks.”