Wednesday, March 18, 2015

Hawk, Doves, and Canaries

Central bankers are usually classified as either hawks or doves. This post is devoted to a third and rare breed; today's monetary policy canaries. Having taken their respective deposit rates to -0.75%, deeper into negative territory than any other bank in history (save the Swedes), the Swiss National Bank and Denmark's Nationalbank are the canaries of the central banking world, plumbing depths that everyone assumes to be dangerous. Other central bankers, in particular the ECB's Mario Draghi, will no doubt be watching the Swiss and Danes quite closely. The information these two nations generate as they go deep into the bowels of negative rate territory will give a good indication of the level to which the others can safely reduce their own rates before hitting their respective effective lower bounds.

That there is an effective lower bound to rates stems from the fact that at some negative nominal interest rate, everyone will choose to convert deposits into cash, preferring to pay storage and handling costs on the underlying paper instrument than enduring a negative interest penalty on the electronic equivalent. Once this process starts, a central bank will be unwilling to push rates much lower given the possibility that the economy's entire deposit base gets converted into paper.

Last week Danish central banker Lars Rohde told the WSJ that while there is some lower bound for negative interest rates, "we haven't found it yet." What Rohde was basically saying is that the marginal storage costs of Danish cash are higher than -0.75%, Denmark's current monetary policy rate. If costs were lower, than Denmark's largest and most efficient cash hoarders, Danish banks, would have already rushed to convert their deposits held at the Nationalbank into banknotes—and Rohde would have found his as-yet inactive lower bound. Given his confident tone, Rohde must not be seeing much demand for banknotes. He would know. As his nation's central banker, he's privy to real time information on the quantity of cash that the central bank is being called upon to print up and provide to commercial banks.

We can get a rough feel for the data that Rohde is seeing. The chart below shows the year-over-year percent increase in end-of-month Danish cash and coin outstanding. The data is current to the end of February, eighteen days ago. Given that Denmark's deposit rate was initially reduced to -0.5% on January 29 and then to -0.75% on February 5, the data affords us an insight into the first thirty or so days of Danish cash demand at ultra low interest rates.

The chart shows that the yearly rate of growth in cash outstanding has accelerated slightly but is well within its normal range. What does this tell us about paper storage costs? Let's crunch some numbers. Danish banks currently have around 350 billion krone in funds on deposit at the Danish Nationalbanken in the form of certificates of deposit. This amounts to about US$50 billion. The central bank's -0.75% interest rate imposes yearly charges of around 2.5 billion krone, or US$375 million, on those deposits. In choosing to hold funds at the central bank, Danish banks are revealing that the cost of handling and storing paper cash must be somewhere above $375 million a year, else they'd have already started to convert into the cheaper alternative.

Keep in mind that this illustrates just thirty days with deep negative rates. With cash use in Denmark having been stagnant for a number of years (see chart here), vault space may have been re-purposed for other uses—maybe employees have been parking their commuter bikes in unused vaults or storing old bank documents in them. It could take time for vaults to be cleaned up. If so, a dash into cash could simply be delayed by a few weeks.

When Denmark hits its effective lower bound, what will the above chart look like? The 350 billion krone in deposits that banks currently keep at the central bank would quickly be converted into cash. Since Denmark currently has just 65 billion krone in notes and coin in circulation, we'd see a quintupling in cash outstanding. For comparison's sake, this would dwarf previous episodes of strong krone cash demand, like Y2K.

And what of our other canary, the SNB? The Swiss, so timely on matters of transport, don't think that up-to-date central banking data is important. The SNB's most recent data on cash outstanding is too stale to give a good idea how the Swiss have reacted so far to -0.75% rates. All we've got is anecdotes. This article reports that a Swiss pension fund attempted to withdraw a portion of its investments from its bank and hold it in a vault, thus saving 25,000 francs per 10 million francs after storage & handling costs, the implication being that these costs run around 0.5% a year. We'll have to wait for more data to come out of Switzerland before we can gauge whether it is at its effective lower bound.

What we do know is that Switzerland's bound will be much tighter than Denmark's. That's because while Denmark's largest denomination note is the 1000 krone note (worth about US$141), Switzerland's largest note is the 1000 franc note (worth about US$993.) That makes a US$1 million bundle of Danish notes seven times more bulky than that same bundle of Swiss notes, resulting in higher storage costs. This has important implications, since Mario Draghi's ECB, which issues a 500 euro note (worth US$530), likely has an effective lower bound that lies somewhere in between these two.

All of these data points may seem quite being arcane, but they have a very real policy significance. They're the difference between a central bank running out of interest rate ammunition, or buying itself an extra ten 10 basis point rate cuts.


  1. Is the main use maintaining a stable euro exchange rate, allowing rates to go wherever they need to go to accomplish that, floating the rate rather than the currency?

    1. Technically it could just keep the rate fixed and use its ability to make unlimited purchases of euros (ie sales of krone) to maintain the peg to the euro. But because it has already purchased so many euro assets, I think it wants to use the deposit rate to slow down the pressure being placed on the peg.

  2. Another excellent post on this subject.

    This may be a vague question, but in your work have you considered the tax implications of negative interest rates? I suppose both negative interest and storage expenses are deductible expenses for a corporation, so there is an after-tax equivalence in the comparison.

    Maybe not so for individuals, since the interest may be deductible but storage cost doubtfully so. That would be further downward marginal pressure on the effective lower bound, other things equal, at least where individuals have an effect.

    Is there any issue here either way?

    1. You bring up a good point. I haven't thought about these questions, but here are some links:

      I am awful at thinking about taxes so I can't get my head around how this affects the level of the effective lower bound.