Sub-zero interest rates have floor nearby, albeit a shaky one

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The supermoon is seen next to the air-traffic warning light illuminated headquarters of the European Central Bank (ECB) in Frankfurt, Germany, early morning September 28, 2015. REUTERS/Kai Pfaffenbach
The supermoon is seen next to the air-traffic warning light illuminated headquarters of the European Central Bank (ECB) in Frankfurt, Germany, early morning September 28, 2015.

Zero is clearly not the floor for central bank interest rates, but there's still a lower limit nearby, however shaky it may be.

For anyone assuming official interest rates would not or could not go below zero, it's been a sobering year. Four central banks in Europe have broken the taboo and are experimenting with the slightly puzzling concept of negative interest rates.

The European Central Bank as well as the Swiss, Swedish and Danish central banks all now employ negative deposit rates - charging their commercial banks for holding reserves on deposit as yet another way of forcing them to lend more.

Even though this upside-down world of negative rates appears to many to be just a technical quirk in the banking system, households and firms may start to wonder whether negative rates will spread to them given the obvious reluctance of central bankers to admit a floor and draw the line here.

ECB chief Mario Draghi electrified markets last week by holding out the prospect of yet another cut in the ECB's deposit rate of minus 0.2 percent as it battles to get flat lining euro-zone inflation back up to its target of near 2 percent.

Whether negative rates excite or terrify you, most economists reckon there's a limit. They insist a so-called 'lower bound' for rates - only debated in academic circles between the 1930s Depression and the credit crash of 2008 - is still a major and worrying constraint on monetary policy and that the floor is likely just a little below where we are now.

For all the wonkish detail, it's no pinpoint science.

Bank of England studies put the limit about minus 0.5 percent, for example. That's below the current ECB rate, though not as deep as the Swiss National Bank's minus 0.75 percent.

National variations clearly apply, however. The BoE itself has, until recently at least, declined to cut its rates below 0.5 percent - due to the plethora of UK mortgage rates that track the policy rate but also because UK banks have typically never charged customers for current accounts.

But the argument for an interest rate floor that's just slightly negative is relatively simple.

If banks are charged ever larger penalties for depositing reserves with the central bank, the assumption is they will simply transfer the money into physical cash, which even at zero interest would still give them a better return. And their tolerance for negative rates is estimated to be the additional cost of securely stashing those crisp notes away in private vaults.

"The source of the zero lower bound constraint lies in the unrestricted convertibility into cash of reserve accounts at the central bank," according to the annual 'Geneva Report' on the world economy from the UK-based think tank Centre for Economic Policy Research.

But the report - authored by former BoE policymaker Charles Bean, former New York Federal Reserve economist Christian Broda, former Japanese financial diplomat Takatoshi Ito and former Fed governor Randall Kroszner - said the relatively high security cost of holding vast quantities of banknotes meant that this switching doesn't happen immediately that rates go below zero.

"Banks are more likely to decide that it will be worth investing in setting up such secure facilities if central bank deposit rates are likely to be negative frequently and for substantial periods," they wrote, adding the "true floor" is probably close to BoE calculations of minus 0.5 percent.

This is no stone floor, however. Reviewing the report, SNB Vice Chairman Fritz Zurbruegg said "the tipping point is not clearly defined; markets and businesses are very innovative."


But if the zero bound does exist and it's at least close to where we are right now, what happens if inflation still won't rise back to target and further easing is needed? Was Mario Draghi just bluffing by saying he could do whatever it takes?

Facing the risk of a deflationary trap, more bond buying and quantitative easing can at least try to push down long-term borrowing rates. But there are practical and political limits here too on what and just how much bonds to buy, while the benchmark 10-year German bund already yields less than 0.50 percent.

Others suggest inflation targets could be raised to provoke a change in expectations and underline central bank determination. But if you're struggling to get inflation from zero to 2 percent, will it be any easier getting it to 4?

That leaves more radical moves to overcome the lower bound.

One includes getting rid of physical cash altogether to prevent banks switching into it - a plausible idea given the rise of card payments and electronic money. Another proposal involves abandoning the automatic 1-for-1 exchange between cash and reserves. One more alternative suggests banknotes would have to be stamped periodically to retain their legal tender.

Spotlighting Bitcoin's emergence, BoE chief economist Andy Haldane said last month that some form of digital money wallets could be the future for new government-backed currency too and have the advantage of being able to absorb negative rates.

"Perhaps central bank money is ripe for its own great technological leap forward, prompted by the pressing demands of the zero lower bound," he said.

But, even if switching can be avoided, deeply negative rates may cause more problems than they solve by damaging bank balance sheets and stability, fueling increases in risky lending or leading to unintended consequences of banks recouping costs through higher mortgage or corporate lending rates - as seen in Switzerland. Deeply negative interest rates for a protracted period will also create distortions in asset markets.

Together these fears may act as powerfully as any limit on just how negative rates can go.