Digital currencies pave the way for deeply negative interest rates
I think the answer to both questions is yes, and those who agree should already assess the impact on future monetary policy, as dramatic changes are likely over the 30-year treasury period.
The main monetary power of the digital dollar comes from the abolition of banknotes. If people cannot accumulate physical money, it becomes much easier to reduce interest rates to well below zero; otherwise, the zero rate on banknotes stuffed under the mattress looks attractive. And while interest rates can drop well below zero, monetary policy is suddenly much more powerful and better suited to fight deflation.
Before we continue, a quick definition: I’m talking here about the currency issued by the central bank that can be used by you and me, just like banknotes. It may (or may not) pay interest, but this is different from money in a regular bank account, which is created by the commercial bank; the central bank’s existing digital currency, known as reserves, is used only to settle debts between banks and certain other institutions, not available for ordinary use.
Deeply negative rates will not come right away. Initially, central bank digital currencies will almost certainly be designed to behave as much as possible like regular banknotes, to facilitate their adoption and minimize disruption, while the use of physical money will be allowed to disappear. But those close to development agree that monetary prudence should not last.
“Central banks are doing a lot of work to ensure that the CBDC is not seen as a possible monetary policy instrument,” says Benoît Coeuré, head of the innovation hub of the Bank for International Settlements and former policy maker at the Bank for International Settlements. European Central Bank. My point of view is that this discussion will not come until later. “
This is important for investors, because if rates could be seen as deeply negative, it would change the long-term outlook for interest rates and inflation. The ECB has a rate of -0.5%, the Bank of Japan -0.1% and the Swiss National Bank -0.75%. But no one thinks they can go below -1%.
The main limitation is that deeply negative rates would encourage people to switch to banknotes to “not earn” on their savings, instead of losing money. Hoarding large amounts of physical money comes with costs, including storage and insurance against fire or theft, which allows for slightly negative rates. But go far enough, and negative rates would be applied to a increasingly small savings pool, compromising their efficiency and draining banks.
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 as yet untested tools like buying bonds or quantitative easing, central banks could continue to cut rates in the event of a crisis. And they would save considerable money: Trillions of dollars in QE and other experimental policies amounted to a “shadow policy rate” for federal funds of minus 5% by 2011, according to BIS research.
The alternative to the banknote is not the only one preventing central banks from raising rates to -5%.
“It’s not natural,” Mr. Coeuré told me. “Negative rates are not easy to understand. There will be reluctance from both central banks and financial institutions to go there. [deeply negative]. “
Resistance from politicians and the public would make policymakers wary of such drastic policies, and some central bankers are already worried about the side effects of prolonged periods of negative rates. But as Mr Coeuré, who oversaw bond purchases at the ECB, might tell you, what once seemed like incredibly extreme monetary policy can quickly become the norm.
Accept that interest rates can be deeply negative during severe recessions, and there is still a conundrum: Does this lower or increase long-term bond yields?
The argument for lower returns is basic math. A 30-year bond should earn the average fed-funds rate over the period, plus or minus a risk premium. Remove the lower bound on the rates, and the occasional negative rate should mean a lower average, all other things being equal.
As usual in economics, however, not everything else is created equal. The goal of deeply negative rates would be to stimulate the economy, create a faster recovery, and allow the central bank to hike rates faster than if it were stuck at an all-time low for years, like the Fed did. was from 2008 to 2015 (the longest period without a rate change since at least 1954).
If negative rates worked, it might not mean a lower average over time. Instead, it could mean higher average inflation and similar or even higher rates, as the economy could quickly emerge from the rut of secular stagnation and rates and inflation returning to normal.
“It’s hard to say in which direction this would go,” says Eswar Prasad, professor of economics at Cornell University and author of an upcoming book on digital currencies, “The Future of Money.” “In times of extreme peril, it could make all the difference. “
Making a decision depends on how you view monetary policy. If you think it doesn’t really work as a stimulus anyway, then negative rates would provide little or no additional support; a Japanese economy with even more negative rates could simply have lower bond yields, and still no inflation.
If you agree with central banks that interest rates are a powerful tool to jumpstart the economy, then digital currency removes the asymmetry that prevents rates from being used to fight deflation. . This should remove much of the risk of persistent deflation, justifying higher long-term bond yields.
Either way, interest rates matter to bond yields, and electronic money can give central banks more freedom with interest rates. How long this will take is up for debate, but some countries are already beyond the experimental stage, and policymakers are feeling the pressure from crypto developers, especially the so-called stablecoins tied to the value of ordinary currency. It’s time for long-term investors to start paying attention.
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