Central bank digital currency (CBDC) is an innovation whose time has arrived. By adopting CBDC and eliminating cash as we know it, central banks can arm themselves with a powerful tool to boost demand when inflation is too low, economic activity is too weak, or a currency is overvalued. Moving to CBDC entails few costs and many benefits.
The chief benefit is the ability to by-pass the effective lower bound (ELB) on nominal interest rates, which otherwise prevents central banks from responding sufficiently to deflation, protracted economic weakness, very low neutral real interest rates, or overvalued currencies.
Prepare for the next crisis
We recently discussed why negative policy rates have re-entered the policy discussion in some parts of the world, even as global market rates have risen. That discussion centered on the role of negative interest rates as a currency and capital account management tool. But it also mentions that policymakers are currently ill-prepared for a return of very weak aggregate demand and below-target inflation.
Growth is slowing globally outside of the US and inflation has been falling. In Canada and Sweden, to cite but two examples, unemployment has been rising and inflation is either already below the target (0.82% in Sweden), or just below the mid-point of its target range (1.8% Canada). In both countries, inflation is falling, even though the exchange rate has been weak. There is therefore a prima facie case for stimulating aggregate demand.
But the future of countercyclical aggregate demand management is deeply uncertain. Large fiscal deficits and high public debt constrain further fiscal stimulus without monetary support in many countries. Monetary support via central bank asset purchases (QE) did not work as intended. Central banks will be put off by the continued large losses they incurred on their huge holdings of very low interest rate long-duration securities when interest rates rose subsequently. They should be concerned by the large fiscal deficits and asset bubbles they likely contributed to.
Although financial markets are projecting policy rates to remain clearly positive outside Switzerland, policymakers need to expand their toolbox now. It is in good times that policy must prepare for future challenges.
What we have (not) learned from the recent past
Assessments of negative policy rates used in recent years have been mixed. But those assessments suffer from an important limitation: policy rates only went slightly into negative territory, and we have no experience with significantly negative policy rates anywhere.
The Swiss National Bank set its policy rate at -0.75% from January 2015 until June 2022 – the most negative policy rate ever. The ECB had a deposit rate of -0.50%. Neither the Fed nor the Bank of England (BoE) utilized the very modest negative interest space they had. The target zone for the Federal Funds Rate (FFR) never went below 0.00% to 0.25% (from December 2008 till December 2015 and from March 2020 till March 2022). The BoE’s Bank Rate never went below 0.10%.
One reason why central banks did not set more negative policy rates is the existence of an asset with a zero nominal interest rate – central bank currency notes and coins. Savers unwilling to hold deposits with negative interest rates can evade them by moving into cash. Because of the carry cost of physical currency (storage and safekeeping) central banks can set modestly negative interest rates before large-scale conversion into cash sets in. This conversion risk is also a major factor why commercial banks were so reluctant to introduce negative interest rates on household or small commercial deposits, and why negative rates weighed on bank net interest rate margins.
Why negative nominal rates are needed
Without the constraint of the effective lower bound, policy rates in the US surely should have been significantly negative in the first half of 2009, as well as in mid-2020 (during the pandemic economic free-fall).
A simple way of quantifying this is to apply the Taylor Rule, a well-known rule of thumb for the policy rate set by a central bank targeting full employment and stable prices. The actual policy rate under our version of the Taylor Rule (used by Bernanke in 2015) is the sum of three terms. The first is the neutral policy rate; the second is the proportional output gap (the difference between actual real GDP and potential real GDP as a percentage of potential real GDP); the third is 1.5 times the difference between the actual and the target inflation rate. The neutral policy rate is neutral real interest rate plus the target rate of inflation.
Consider the first two quarters of 2009. Take the neutral real interest rate to be 1%, somewhat higher than the New York Fed estimates. The target rate of inflation is 2%. We take the proportional output gap to be minus five percent – slightly lower than the estimates of the St. Louis Fed. Take the inflation rate to be 1%, slightly higher than the core PCE inflation rate. This results in a Taylor-Rule Fed Funds estimate of -3.5%, far below policy rates set anywhere in 2009.
Addressing concerns
There are of course several open questions about negative policy rates.
First, the distortionary side effects of negative rates are generally viewed to have been modest, but likely to rise over time. But a main reason that negative nominal policy rates have caused financial distortions is the existence of the ELB. One way of getting rid of the ELB, therefore, would be to abolish coins and paper currency and replace them with an interest-bearing retail central bank digital currency (CBDC). That digital currency would allow both online and offline transactions and would have no cap on the size of accounts or transactions. By abolishing cash and introducing a CBDC, central banks would gain a powerful new tool to stimulate economic activity and boost inflation during times when a very negative nominal interest rate represents the optimal policy setting.
Second, how effective would a -3.5% Fed Funds rate have been in stimulating aggregate demand in 2009 (or in 2020)? We have no empirical evidence on the matter. But there is nothing abnormal about negative nominal interest rates. Why should the nominal value of money today always be higher than tomorrow? The real (i.e., inflation-adjusted) interest rate on coins and currency has been negative throughout most of history. Negative real interest rates on non-monetary financial instruments have also been common. Distortions occur when economic agents confuse real and nominal interest rates, but why would such distortions be more significant when nominal rates are negative than positive?
To be sure, we have no data set from which to draw upon. History does not offer examples of deeply negative nominal interest rates. But based on the experience of less negative interest rates that occurred since the global financial crisis, we have seen no evidence of adverse confidence effects from negative nominal interest rates. It is, of course, possible that the positive substitution effects on spending given a cut in the nominal policy rate to a negative level could be partly, or even completely offset by the negative income effects for lenders and savers. Yet, borrowers would experience positive income effects. In the end, the answer is an empirical one, for we do not have the data to evaluate it because there is no history of materially negative nominal interest rates.
Might commercial banks be put at risk from the issuance of CBDC? Perhaps. Private demand for commercial bank deposits (checking accounts) would likely fall. If that were deemed problematic (because it reduces financial intermediation by commercial banks), it could be addressed by the central bank depositing with commercial banks the receipts from CBDC issuance in excess of the pre-CBDC issuance of paper currency.
Opposition is political, not economic
Indeed, the main argument against the abolition of paper currency is political, not economic or financial. The holders of paper currency are anonymous, and so are transactions involving paper currency. This privacy effect is valuable when there are concerns about intrusive and overbearing governments or private entities that could abuse the information provided by traceable deposit-like means of payment like a retail CBDC.
Those privacy concerns could be addressed to some extent by putting the CDBC on a blockchain, like Bitcoin. While transactions between wallets on the blockchain would be in the public domain, the beneficial owners of the wallets could be anonymous.
There is of course a counterargument concerning the anonymity of paper currency and of a blockchain-based CBDC. Anonymity makes paper currency the preferred store of value and means of payment for criminals. Tax evasion, bribery and corruption, the financing of terrorism and many other violent and non-violent illicit activities are facilitated by the existence of paper money. Private cryptocurrencies like bitcoin are also favored by the criminal community.
For us, the negative effects of anonymity outweigh the positive effects in countries with robust democratic political institutions. We therefore favor a ledger-based, centralized CDBC. Such a centralized retail CBDC would be equivalent to every CBDC holder of having a checkable account with the central bank. It can, of course, be implemented by commercial banks offering a checking account guaranteed by the central bank, with the direct operational involvement of the central bank only at the wholesale level, through commercial bank deposits with the central bank.
Conclusion
In sum, the economic arguments for getting rid of the effective lower bound on nominal interest rates are powerful and significant. Negative central bank policy rates probably trump Quantitative Easing as a demand management tool. Getting rid of the ELB gives the central banks an additional degree of freedom to respond to adverse economic or financial shocks. Getting rid of the effective lower bound requires that we abolish paper currency and coins and move to a ledger-based digital currency.
Given the obvious advantages of a complete transition to CBDC, it is astonishing and dismaying that the leading central banks are considering CBDCs as non-interest-bearing, with individual accounts of limited size, circulating in tandem with paper currency. That’s a foolish half-step and a missed opportunity.