Friday, April 24, 2015

Plumbing the depths of the effective lower bound

Unfathomable Depths by Ibai Acevedo

Denmark's Nationalbank and the Swiss National Bank are the world's most interesting central banks right now. As the two of them push their deposit rates to record low levels of -0.75%, they're testing the market's limit for bearing negative nominal interest rates. The ECB takes second prize as it has been maintaining a -0.2% deposit rate since September 2014.

At some point, investors will flee deposits into 0%-yielding cash. This marks the effective lower bound to rates. Has mass paper storage begun? The last time I ran through the data was in my monetary canaries post, which was inconclusive. Let's take a quick glance at the updated data.

To gauge where we are relative to the effective lower bound, I'm most interested in the demand for large denomination notes, which bear the lowest costs of storage. Once a central bank reduces its deposit rate so deep into negative territory that the carrying cost of deposits exceeds the cost of storing a nation's largest value banknote, then it has hit the effective lower bound. Small denominations notes, which have higher storage costs, are not a pivotal part of the picture given the ability of note holders to freely convert low value notes into higher ones.

European Central Bank

The ECB issues the 500 note, which has the second highest purchasing power out of the world's currency notes. I've charted the quantity of 500 euro notes in circulation below, as well as the percent change in the value of all euro denominations:

After declining through 2012 and 2013, we saw a sharp rise in demand for €500 notes, particularly in December 2014 and the first few months of 2015. The red line illustrates the general demand for all denominations of euro cash. Over the last four months the seasonally-adjusted growth rate of banknotes outstanding has risen to its highest level in the last five years.

It's hard to determine how much of this increase can be attributed to the ECB's negative rate policy, initiated when Mario Draghi brought the deposit facility rate to -0.1% in June and -0.2% in September, and how much is due to the Greek fiasco. Growing fears that Greece will either leave the euro or impose capital controls have led to a steady jog out Greek banks. There are two escape routes: Greek's can convert their deposits can into German deposits or into cash.

In an interesting article, Bloomberg's Lorcan Roche Kelly backs out the Greek-specific demand for European cash. Read it for the full details, but the shorter rendition is that a line item on the Bank of Greece's balance sheet allows us to see how many banknotes Greeks are demanding in excess of the Bank of Greece's regular allocation. Kelly finds a large spike beginning in December and extending into 2015, which we can attribute to the bank jog. I've recreated the chart below:

Source: Bloomberg, data to end of March

The approximately €12 billion jump in Greek cash demand corresponds nicely with the recent €7.2 billion spike in €500 notes in circulation across the entire eurozone. The upshot is that a large chunk of the rise in 500 notes over the last few months is probably due to a run on Greek banks, not an escape from negative-yielding ECB deposits. Remove the run and the rise in demand for €500 notes would have been unremarkable, indicating that the eurozone is still far from hitting the effective lower bound.

Swiss National Bank

Because Swiss banknotes are not a direct escape route from the ongoing Greek bank run, SNB cash data should provide a clearer signal of the whereabouts of the effective lower bound than ECB data. The SNB issues the world's most valuable banknote in terms of purchasing power; the 1000 franc note. Below I've plotted the yearly percent change in demand for both the 1000 note and Swiss cash-in-general to the end of February.

There's been slight pickup in the demand for Swiss cash, but nothing dramatic. Its worth pointing out that Swiss paper currency has historically played a safe haven role. Demand tends to spike during episodes of uncertainty, including the 2008 credit crisis and the 2011-12 period, when it seemed like the euro could be torn apart. This means that it is difficult to be sure how much of the recent pickup in demand for Swiss cash stems from the SNB's -0.75% deposit rate and how much is due to fear of a Greek government default, which would create havoc in world markets.  

Danmarks Nationalbank

Our final canary is the Danmarks Nationalbank. Unlike the demand for Swiss paper francs, the demand for Danish paper krone does not usually spike during times of crisis. For instance, during the 2008 credit crisis demand remained muted. This leads me to believe that demand for paper krone provides the clearest indicator yet of the presence (or not) of the effective lower bound. I've charted the year-over-year change in Danish currency in circulation.

In the 55 days that have passed since the Danmarks National bank reduced its rates to -0.75% (February 5), there has been a sustained rise in the demand for cash, as the red data indicate. But I don't think we can describe it as anything out of the ordinary, at least not yet.

Interestingly, in late March the Nationalbank granted Danish banks some wiggle room by providing them with greater access to the Bank's 0% current-account facility. This small adjustment would have reduced Danish banks' incentives to emigrate from -0.75% deposits into cash. Was the central bank's decision to provide this wiggle room a response to private data showing that it had hit the effective lower bound? Who knows.

It may be worth noting even if a central bank finds itself at the effective lower bound, it can forestall the demand for large denomination notes by using moral suasion. Willem Buiter mentions this possibility in his recent note High Time To Get Low, but maintains we have no evidence of this sort of pressure. I'm tempted to agree with him. If either the Danish or Swiss central bankers have put informal embargoes on cash, we would have known about it by now.

The use of moral suasion to prevent large denomination banknote storage would effectively freeze the quantity of high value notes in circulation. In such a scenario, we'd expect the 1000 Sfr note to rise to a slight premium to face value, say 1050 Sfr in bank deposits for each 1000 Sfr in banknotes. Traders would be willing to pay this premium as long as the storage costs on high value notes are lower than the -0.75% penalty set by the SNB on deposits, thus allowing them to earn an excess return on their note holdings. As long as moral suasion remains successful in choking off Swiss banks' demand for cash, each subsequent cut by the SNB into ever deeper negative territory would drive the premium on notes higher. (Assiduous readers will recognize this as the second of three ways for a lazy central banker to escape a liquidity trap.)

In sum, we probably haven't hit the effective lower bound yet. Stay tuned.


  1. JP, would you agree that currency production at the effective lower bound is a good thing for NGDP expansion?

    I've seen some compelling work that the currency component of the monetary base is most important for NGDP prices; while reserves are most important for setting interest rates. The experience of the last few years bears this out, I might point out.

    Low interest rates are often associated with tight monetary policy and slow NGDP. Would you agree or disagree?

    By this measure, currency formation at the effective lower bound is the cure for the disease of low rates and slow NGDP.

    I'm really curious as to how you might respond. Thanks!

    1. Central banks don't control the production of currency. They react passively to demands for currency by banks and the public. As NGDP rises, people draw more currency out of a central bank.

    2. Would you agree that if a government encouraged the widespread production of currency into the economy, this might affect NGDP levels?

      On the other hand, what would happen to NGDP if the government prevented currency usage in the economy?

      Bottom line, I feel that you're being a bit blithe assuming that the causality runs NGDP->currency.

      Couldn't the causality run currency->NGDP, or at least be simultaneous? Why doesn't the same blithe argument apply to reserves, or all forms of money? "Just demanded into existence by NGDP..."

      If NGDP->money, would be no such thing as monetary policy, which I suggest is wrong.

    3. A few points.

      1) It is a fact that central banks do not actively drive cash into the economy. They create central bank deposits. Private banks also create bank deposits. The public determines how many deposits to hold and how many to convert into cash. The banks proceeds to supply this demand by asking to convert their central bank deposits into cash, which the central bank prints up and delivers. No central banker wakes up in the morning and wonders: "So how much cash should I force into the economy today in order to hit my NGDP target?"

      2) That is not to say that a central banker doesn't drive NGDP. They do so by modifying the return they offer on central bank deposits. It's a little tougher once rates hit the effective lower bound, but a few tricks can get you around this temporary obstacle.

    4. Anon, if the central bank is constrained by the lower bound, then rationing currency might well be stimulative, since it removes the constraint. Of course, this would also have the negative side effect of hindering currency use.

      It's not currency->NGDP or NGDP->currency, it's monetary policy -> NGDP & currency etc.

    5. With all due respect, both of your focus on rates is profoundly misguided. Short rates are only a product of base/NGDP. There is no such thing as an effective lower bound. There is only an unwillingness to print up sufficient volumes of the monetary base.

      Please read the following until it sinks in:
      As far as Japan is concerned, the situation is very clear. And it’s a good example. I’m glad you brought it up, because it shows how unreliable interest rates can be as an indicator of appropriate monetary policy.
      During the 1970s, you had the bubble period. Monetary growth was very high. There was a so-called speculative bubble in the stock market. In 1989, the Bank of Japan stepped on the brakes very hard and brought money supply down to negative rates for a while. The stock market broke. The economy went into a recession, and it’s been in a state of quasi recession ever since. Monetary growth has been too low. Now, the Bank of Japan’s argument is, “Oh well, we’ve got the interest rate down to zero; what more can we do?”
      It’s very simple. They can buy long-term government securities, and they can keep buying them and providing high-powered money until the high powered money starts getting the economy in an expansion. What Japan needs is a more expansive domestic monetary policy.
      The Japanese bank has supposedly had, until very recently, a zero interest rate policy. Yet that zero interest rate policy was evidence of an extremely tight monetary policy.

    6. Anon, I've read that Milton Friedman quote. Keep in mind his paradigm was one of the monetary authority targeting a quantity of money. Which is not something that any do (at least none admit to), and in my view would not be a sane policy.

      What you can do is change the target. For example, if you are persistently hitting the lower bound with 2% inflation, you can change to 4% inflation. All else being equal, this would raise interest rates by 2%.

    7. Max, the only power the central bank has is to create base money. Even with interest on reserves, it only creates base money. Monetary policy is base money provision. If NGDP is low, more base money is required, full stop.

      You put a lot of faith in targets. Has the Fed announced a inflation target and stated its intended reaction if it misses? No.

      What level of negative interest rates do you consider stimulative, anyway? No, you seem to think that by slashing the monetary base, you'll stimulate. Truly bizarre.

      Again, all the CB can do is create base money. Currency production is far more "credible" and a form of near permanent base money formation than reserves, which can disappear with a stroke of a button.

      If NDGP is slow, more base money is required. Consider also that money targeting may be a much better policy, and more credible at the extremes - high inflation and zero rates - than a currency-free, negative rate regime that you and JP favor.

      The relationship to rates is curvilinear. CBs have to target quantities of base money at the extremes.

    8. So if we were to see a long and sustained decline in paper currency production, say over a decade, you'd predict that this would cause a decline in NGDP?

    9. JP, let me preface by saying I really like your stuff, including the above. Fascinating and cool. I just think you've been deeply misled re currency.

      ...and the answer to your Q is "not necessarily". Perhaps cowrie shells are being used to transact. Perhaps half of the population has gone on food stamps. Or, more likely, the government is using suasion to reduce cash usage, say with money laundering laws and moral suasion with banks: $10,000 in currency, getting smaller in real terms by the day, perhaps.

      Or we could take the biggest state-sponsored cash-free economy experiment : prison! We could transact in cigarettes or sardines. Yet I think even you would acknowledge this to be an unstable sub-optimal economy: introducing currency would expand the prison economy, so to speak.

      Still, overleveraged banks took us to the brink of a global economic meltdown in 2008, and so you want to increase reliance on the bank sector -- no exit, no cash. This is more than blind trust, it's fanaticism. Why, exactly, is the banking system trustworthy this time -- is this time different?!

      Besides, the over-leveraged banking system was recapitalized with reserves; currency would recapitalize the over-leveraged NGDP economy just as effectively.

      You are blithely demanding that the population give up it's senior base money position in currency, and accept a restructured deeply subordinated demand deposit position with nasty counterparty risk: i.e. bail-ins. Give up senior currency, accept subordinated fifth-position (behind derivatives and bank bonds) demand deposits?

      Nope, sorry. Currency is senior, demand deposits are deeply subordinated: trillions in interest rate swaps get paid first, you last. And you pay up in greater fees, negative rates, and greater sales taxes on a captive market for the privilege. And this is a better economy? Sounds likes cram-down debt restructuring. No deal.

      It strikes me sometimes that you are most interested in bank welfare, not monetary policy to govern AD.

  2. Put a high tax economy together with deflation, and you will get increasing use of paper money and then increasing off-the-books transactions.
    It does not seem deflation can work in a modern developed economy.

  3. via

    “The president of the pension funds association ASIP, Hanspeter Konrad, has been irritated for weeks that pension funds are suffering from negative interest rates. He says: “We simply cannot understand that the banks are butting in here”. Konrad suspects that the National Bank is exerting its influence.
    Indeed, the SNB confirms that it doesn’t like to see the hoarding of cash to circumvent its negative interest rate policy. “The National Bank has therefore recommended to the banks to approach withdrawal demands in a restrictive manner.”
    Hans Giger, professor eremitus at the University of Zurich, says to this that the question how far the SNB can go is legally complicated. While the SNB is not allowed to influence the contract between a bank and a pension fund, it can however “issue directives to the banks in the collective interest of the Swiss economy”. What banks do with the SNB’s directives is however up to them.

    1. Interesting. I put that article through Google translate last month and some how lost the bits on directives. If in fact the SNB is issuing directives recommending that banks restrict cash withdrawals than that qualifies as moral suasion.

  4. Dear JP,
    thank you for your great posts about negative rates and lazy central banking.
    I only know the Swiss case and estimated about CHF 10bn worth of hoarding. That seems along your lines. I'd also say that demand spiked in volatile periods, and only little with the move into negative rates.

    Hoarding this size is clearly not an issue for monetary policy. But it made me wonder when hoarding becomes an issue for monetary policy at all. I was wondering if rather, the effective ZLB is equal to the cost of switching to a new medium of exchange.

    Isn't the only case where we worry about hoarding the switch to a cash-based economy? At any point before that, the central bank is still in charge albeit with an unimaginably scaled balance sheet. Even if we would worry about domestic financial market distortions before that point, the consequence is the same:

    Why would any one put up with the hassle of a cash-based or financially disrupted economy if there is a USD or Euro that could be used as well? People would not hoard currency, the would switch out of it altogether, no?

    I'm missing something and would appreciate if you could point it out.

  5. Ok, what I meant was the cost of coordinating on a new medium of exchange. But it would likely be one of those two.

    1. You bring up a good point. I think the costs of switching to a new medium of exchange are very high given network effects. Also, even if the Swiss adopt euros as a medium of exchange, this doesn't start to become a problem for the execution of SNB monetary policy until the euro is also adopted as the unit of account. We know that nations are willing to endure high inflation for long periods of time before switching out of the domestic currency as medium of exchange and pricing unit, so the Swiss would probably endure a cash economy for some time.

      Cecchetti and Shoenholtz hypothesize that a pure cash economy might not even be the necessary end point once the effective lower bound has been crossed. If banks innovate by making cash reserve accounts available--ETF units backed by cash in vaults--then people can get all the benefits of a regular banking system (checks, transfers, etc) and the 0% feature of cash:

      The SNB could in turn combat this by removing large denomination notes, ceasing to issue large denominations, or imposing fees on them.

  6. Perhaps a quasi-religious parable might help clear up the negativity, i.e. the angst of this new-clear impending debacle, putting it in a correct historical perspective?

    And what fearless soul will spark the sorely needed "Reformation"?

    Snowden, Jesus And Interest Rates
    by Martin Sibileau

    . . .
    Like with any other revolutionary thesis, the Christian thesis had a strong element of dogma. Early Christians understood and accepted that they would most likely suffer, but that such suffering in this world was going to be rewarded in the next one. Their mission transcended their earthly lifetime. In other words, Christians back then dogmatically believed in the existence of a negative discount rate and a very long-term curve. It was negative because future happiness was preferred to present pleasures; and it was a very long-term horizon because said happiness would be obtained in the after life.

    Of course, nobody could manipulate such discount rate like central banks do today. It was going to take fifteen centuries before a banker and pope, Leo X, born Giovanni di Lorenzo de Medici, would manage to do just that, changing the relative terms between present and future with leverage. Leo X sold “paper” redemptions in the form of so called “indulgences”, which dramatically diminished the cost of earning forgiveness in the other world. He even contracted the Fugger's bank for the collection of the indulgences. And that marked the end, for Reformation was triggered.

    Is it therefore possible that with zero interest rates the success of Snowden’s message be negated? I think so, which leaves the burden of the protest to the younger generations. They will end up paying the cost today’s consumption.

  7. The Greek Drachma was exchanged @ 340.75 drachmas to the Euro. What if the neo-drachma is fixed at 100 neo drachmas to the euro, and it is a purely electronic currency. Greece was circulating roughly €9 billion equivalent in drachmas in the year 2000. Would a reconstituted Greece which is not a member of the Euro-zone be able to use it's electronic currency, while at the same time private individuals are free to accept Euro cash just as individuals from any country are free to accept foreign currency?