When trying to stimulate economies by imposing negative interest rates, central banks run into a problem: they can’t stop money leaking out of the banking system and into cash.
Around the world, there has been growing demand for high-denomination banknotes, which enable savers to preserve capital, rather than seeing it chipped away by negative rates on bank deposit accounts.
Governments have sought to counter this trend by withdrawing high-denomination banknotes from circulation, making hoarding physically more cumbersome.
Last year the International Monetary Fund (IMF) suggested a solution to this dilemma: central banks could issue their own digital currencies, it suggested.
The central banks could then apply negative rates, causing the value of this electronic cash to fall over time.
And if physical cash co-existed with the electronic money, the IMF said, the authorities could prevent hoarding by imposing a conversion rate between cash and e-money, making sure that the conversion rate depreciated at the same rate as the negative interest rate on e-money.
This proposal is so far untested. But yesterday the UK’s central bank stepped into the debate with a new discussion paper on central bank digital currency (CBDC).
If it introduced an unremunerated digital currency in future, said the Bank of England— an unremunerated digital currency is one not paying or charging any interest—this could put an effective floor (or ‘lower bound’) under interest rates, preventing them from moving into negative territory.
In practice, storage costs for cash mean that central banks may be able to set policy rates a bit below zero without causing savers to hoard banknotes on a large scale, the Bank added.
But what if a central bank wanted to impose a negative rate on a new electronic currency?
The Bank of England left this option open in its discussion paper.
“If interest rates are, and continue to be, low then central banks are likely to be constrained by the lower bound more frequently than historically was the case,” it said.
Negative rates were undermining savings and the banking system, encouraging excessive risk-taking by non-banks, subsidising zombie companies and eroding Sweden’s growth and productivity potential
“A CBDC that could be remunerated at a negative rate could be used to relax that constraint, to the extent that the constraint was caused by the fact that cash pays zero.”
“This could, theoretically, widen the policy options available and avoid the economic costs of having monetary policy hit the effective lower bound, potentially improving economic outcomes.”
However, the Bank added that any continuing large-scale use of cash might prevent this option being used. It also said that the financial system would need structural reform for a policy of negative rates to work.
“The wider effect of setting a negative interest rate on CBDC could be limited if cash use remains prevalent in the economy and cash storage costs are not excessive,” the Bank said in its discussion paper.
“And for this benefit to be realised the issues related to the structure of the financial system, which determine the current effective lower bound for Bank Rate, would need to have changed.”
Despite their broadening use by central banks, negative rate policies remain highly controversial.
Recently, Sweden’s central bank, the Riksbank, which pioneered a negative interest rate policy in 2013, raised its repo rate to zero after keeping it below that level for nearly five years.
Bloomberg columnist Mohammed El-Erian said that the Riksbank’s policy change had been motivated by concerns that negative rates were undermining savings and the banking system, encouraging excessive risk-taking by non-banks, subsidising zombie companies and eroding Sweden’s growth and productivity potential.
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