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 there is potential for dramatic change within the 30-year Treasury’s time frame.

The main monetary power of the digital dollar comes from the abolition of banknotes. If people cannot deposit physical money, it becomes very easy to cut interest rates far below zero; Otherwise, zero rate on banknotes stuffed under the mattress looks attractive. And if interest rates can drop far below zero, monetary policy suddenly becomes more powerful and better suited to deal with deflation.

Before moving on, a quick definition: I’m talking here about money issued by a central bank that is usable by you and me, just as banknotes are. It may (or may not) pay interest, but it is different from money in a normal bank account, which is created by a commercial bank; The existing central bank digital currency, known as a reserve, is used only to settle debt between banks and certain other institutions, which is not available for general use.

Deep negative rates will not come immediately. Initially, central bank digital currencies will almost certainly be designed to behave like normal banknotes as much as possible, to facilitate their adoption and minimize disruption, while eliminating the use of physical cash. will be allowed. But those close to the development agree that monetary caution is unlikely to last long.

Benot Coeur, Head of the Bank for International Settlements Innovation Hub and former European Central Bank policy maker, says, “Central banks are making great efforts to ensure that CBDCs are not viewed as a potential monetary-policy instrument. ” I believe this discussion will take place only later.”

This matters to investors, because if rates can be taken deeply negative it will alter the long-term outlook for interest rates and inflation. The ECB rate is -0.5%, the Bank of Japan -0.1% and the Swiss National Bank -0.75%. But nobody thinks they can go below -1%.

The main limitation is that deeply negative rates encourage people to switch to banknotes in order to “earn” zero on their savings rather than lose money. Storing large amounts of physical money has a cost, including storage and insurance against fire or theft, allowing for slightly negative rates. But go deep enough, and negative rates will be applied to an ever-shrinking pool of savings, undermining their efficacy and depleting banks.

The monetary impact of removing, or at least reducing, this effective lower limit, as economists call it, is profound. Instead of turning to newer and still unproven instruments such as the bond-buying of quantitative easing, central banks will be able to cut rates in the event of a crisis. And they’ll go a long way—according to BIS research, trillions of dollars of QE and other experimental policies were the equivalent of a “shadow policy rate” for federal funds of minus 5% by 2011.

The banknote option isn’t the only thing stopping central banks from charging rates up to -5%.

“It’s not natural,” Mr. Coeur told me. “Negative rates are not easy to understand. There will be reluctance by both central banks and financial institutions to go there. [deeply negative]”

Resistance from politicians and the public will alert policymakers to such radical policies, and some central bankers are already concerned about the long-term ill effects of negative rates. But as Mr. Coure, who oversaw bond-buying at the ECB, can tell you, what once seemed impossibly excessive monetary policy may soon become the norm.

Accept that interest rates can turn deeply negative in a severe recession, and there’s still a conundrum: Does this make long bond yields lower or higher?

The low yield argument is basic math. A 30-year bond must receive an average of the fed-funds rate over the period, plus or minus a risk premium. Remove the lower limit on rates, and sometimes a negative rate should mean a lower average, all else being equal.

As always in economics, however, all else is not equal. Deeply negative rates are intended to stimulate the economy, create a sharp recovery and allow the central bank to raise rates again if it had been stuck at a lower limit for years, as the Fed did from 2008 to 2015. . Longest period without rate change since at least 1954).

If negative rates work, it may not mean the average will decrease over time. Instead, it can mean higher average inflation, and similar or even higher rates, as the economy can quickly move out of the grip of secular stagnation, and rates and inflation return to normal.

“It’s hard to say which way it will go,” says Ishwar Prasad, a professor of economics at Cornell University and author of the forthcoming book on digital currencies, “The Future of Money.” “In times of extreme crisis, it can make a difference.”

Deciding comes down to how you view monetary policy. If you think it doesn’t really work as an incentive anyway, negative rates will provide little or no additional support; Japan’s economy may have even lower bond yields with more negative rates, and yet no inflation.

If you agree with central banks that interest rates are a powerful tool for refueling the economy, digital currency removes the asymmetry that prevents rates from being used to combat deflation. This should remove the risk of persistent deflation, justifying higher long-term bond yields.

Either way, interest rates matter when it comes to bond yields, and electronic money can give central banks more freedom with interest rates. How long that takes is up for debate, but some countries have already moved past the experimental stage, and policy makers are feeling the pressure of crypto developers, especially so-called stablecoins, to be tied to the value of the common currency. It’s time for long-term investors to start paying attention.