The ECB’s recent decision to lower the deposit rate – the rate it pays to commercial banks for excess reserves – to 0% marks a new chapter in the developed world central banks’ response to the ongoing financial crisis. The EUR dropped over 4% against the USD in the following days as international investors switched out of euro-denominated reserves. Soon after the ECB’s announcement there were reports speculating that the Fed would consider lowering the IOER (the rate it pays to banks for excess reserves, currently 0.25%), and that the Bank of England would lower its deposit rate too. Moreover, the Bank of Japan lowered the floor, from 0.10%, it pays to purchase government bonds in its so-called Rinban operations. The world of competitive devaluations is alive and well, and being played out in the arcane world of central bank deposit rates.
However, there is more to come. No sooner had the ECB made its rate cut, forecasters were pencilling in more, with the corollary that the deposit rate would soon go negative. That is, if commercial banks wanted to hold excess reserves at the ECB, they would have to pay for the privilege.
We think this will come to pass, and it won’t be long before most if not all of the major central banks are operating some form of negative interest rate system. We think this is important as it marks a seachange in the attitude of central banks to a long-running problem of the current monetary policy framework.
In essence, the tools available to central banks are asymmetric. In response to a booming economy with ever rising inflation, a central bank can use its main tool – the overnight interest rate that it sets – to eventually bring inflation under control and cool down the economy to a more sustainable pace. No matter how high the inflation rate, the bank can keep raising the interest rate in response.
But, throughout this financial crisis, central banks have been fighting a different problem. The huge contraction in the shadow banking system following the subprime and Lehman busts left a yawning gap in the amount of credit available in the financial system. Unless debt were to be defaulted on en masse – something no government or central bank wants to countenance – the only solution has been for governments to step in and assume the extra debt burden. Central banks have so far assisted their respective governments by buying up government debt in quantitative easing programmes.
Central banks have been battling to resuscitate something called the ‘money multiplier’. This is, essentially, the ratio between the money created by the central bank (eg that which it created to buy government debt when it quantitatively eased) and the money created by the private sector. As the chart below shows, this collapsed after the financial crisis beginning late 2007, and has been falling for almost all of the time since.
To stimulate spending and to try to encourage the private sector to start lending again, central banks in developed countries slashed interest rates to close to zero. But this is where the asymmetry kicks in. Taking rates less than zero is non-trivial. And for one good reason: the existence of cash. Cash – which in technical terms, is an infinite maturity bearer bond which pays 0% interest – limits the ability of central banks to impose negative interest rates.
If, for instance, the ECB were to impose negative interest rates on excess reserves, then commercial banks could always swap these reserves into currency or actual vault cash and therefore not be penalised at all (after all earning 0% interest is better than a negative rate). There may be practical impediments to this, such as insurance, and taking physical delivery of actual cash. Alternatively, banks could move their reserves from the excess reserve account at the central bank and switch them to the current account (analogous to a regular bank account holder switching their funds from their savings account to their current account). This has already happened to some extent at the ECB. Yet, in a negative interest rate environment, it is likely the central bank would impose a ceiling on the amount that can be held in the current account.
Nevertheless, the existence of currency makes it difficult for central banks to achieve their goals when interest rates are at or close to their lower bound (this is known as the ‘liquidity trap’). Which is why, in the future, policymakers may look at ways to circumvent this ‘anomaly’. For instance, one way may be to eliminate cash altogether and use only an electronic form of currency. More and more transactions take place electronically, so this is not far-fetched. With electronic cash, central banks would be able to impose negative interest rates on currency as easily as they set positive ones.
So the one refuge savers still have – ie they can always hold cash, even if it earns 0% interest (and in real terms, it already earns a negative return) – may be the next totem to fall in response to the financial crisis. The monetary authorities would move closer to asserting absolute control over money.
As we said above, esoteric, negative interest rates that central banks set in their activities with commercial banks may be the first, unsettling steps in this process of the complete appropriation of peoples’ choices in how they save – and when and how they spend – their money. Indeed, Sweden has already tried negative rates, and Denmark has them currently. These countries are harbingers of what is to come.
In this new paradigm, gold becomes even more desirable. It pays 0% interest, and the only way to force this negative is to tax the holding of it. Make no mistake this may happen, but there will always be a jurisdiction that will not agree – or need to agree – with taxing the purest form wealth there is. Gold owners can always shift their holdings to such places.
Owning gold is the best way to hedge yourself from the complete autonomy monetary policymakers are incrementally asserting over all forms of money. Negative interest rates are merely an entrée in this process. Gold is ever more transparently becoming the last refuge in a world headed to monetary dominance.