Article 3-2
​Zero Boundary of Nominal Interest Rate

Originally published February 2, 2015
Last edited : December 8, 2016
By Michio Suginoo

[1] Zero boundary for Nominal Interest Rate

Deflation is deemed an absolute villain by any central banker in our fiat-money world. What makes deflation an absolute villain in our modern world?

Deflation is deemed a villain because it deprives central bankers of room for policy manoeuvres in the world of fiat-currency. By the time a persistent deflationary pressure emerges, central bankers should have dropped the nominal rate of monetary policy interest instruments to near zero in order to prevent it. The question then arises whether central bankers can let interest rates decline indefinitely below zero.

As illustrated further on in this reading, even if general price deflates further, central bankers cannot let nominal saving rates decline below the zero boundary—even while they might be successful in introducing negative rates within enforceable policy rates. Once private lending and deposit rates go below zero, economic actors in the private sector will find ways to denounce it. In this sense, to begin with, negative policy rates might not be as effective as  intended and may not boost private sector spending. In this context, facing deflationary pressure, if any, central bankers would have very limited room to manoeuvre in their pursuit for counter-cyclical policy measures.

Here is a statement that symbolizes an orthodox view:

“Interest Rates on riskless assets cannot fall below zero, as cash guarantees a zero nominal return.” (Borio, C. & Filardo, A. J., 2004)

Nevertheless, there are some special occasions when central bankers take extraordinary measures to bring nominal interest rates to below the zero level. On July 8, 2009 in the aftermath of the Great Financial Crisis, the Swedish central bank, Riksbank, introduced negative nominal rates on deposit rates (Riksbank, 2009 July 8). According to Riksbank, in this case, the deposit rate is a monetary policy instrument: “the rate of interest that banks receive when they deposit funds in their accounts at the Riksbank overnight and it is normally 0.75 percentage points lower than repo rate (the Riksbank’s policy rate).” (Riksbank, u.d.) In other words, banks are required to make periodic payments to the central bank as depositors. It is a form of tax imposed by the central bank. It is a form of tax that was proposed earlier by Silvio Gesell.

“In Gesell’s view, money holders can exert their economic power by forcing borrowers to pay a basic interest (German:”Ur-Zins”) and the tax on money aims at eliminating this advantage of money holders and therefore at reducing the riskless nominal interest rate, which will reach 0 in the long run. When accumulation of capital does not run anymore into the lock of positive nominal interest rates this will lead to the termination of capital rents, and the market economy will be free of "capitalism". This is basically the same argument as Keynes’ "euthanasia of the rentiers". Thus, Gesell hinted at social reform of the capitalist system, maintaining property rights and the market system, but eliminating undue capital rents (effortless income) in the long run by monetary and land reform.” (Menner, 2011)
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The negative nominal interest rate case of Riksbank was in a limited scale, in the sense that the negative rate was applied only within banks’ reserve accounts at the central bank, but was never extended into commercial and retail lending rates and "private" deposit rates on the street. In order to distinguish interest rates applied to private lending and private deposits from those of monetary instruments applied to banks by central banks, let us refer the former rates as "private" interest rates throughout this article.

Money, when not saved in a bank account, is anonymous: it is non-interest bearing, non-redeemable legal tender. On the contrary, deposited money is viewed as “registered bonds” and traceable (Ilgmann & Menner, 2011): therefore, it has no anonymity. In this context, the feature of fiat money separates the economic reality between deposited money in a bank account and cash hoarded at home: registered money and anonymous money, respectively. While the deposited money is subject to charge under a negative deposit rate condition, cash hoarded at home is anonymous and free from any charges. It is very intuitive.
Here is an explanation:

On the street, beyond the reserve accounts of the central bank, negative nominal interest rates, if applied to private lending and private deposits, would face operational limitations under the current fiat-money currency system (unregistered instrument). Negative nominal "private" interest rates translate into a counter-intuitive notion that lenders subsidize borrowers through lending. Lenders would have to make periodical payments (due to the negative sign in nominal "private" lending rates) to borrowers in order to lend money to borrowers. Borrowers would receive periodic revenue from lenders by borrowing money (such an easy business, if any). From a savings perspective, under the current fiat-money regime, savers would withdraw their savings and hoard their money at home to avoid periodic costs arising from negative "private" deposit rate. The negative nominal "private" interest rates－for both private lending and private deposits—would cause a separation in the economic reality between money deposited at the bank and money hoarded at home. The former can be charged, the latter not, which could ultimately lead to social unrest.

The banking business relies on depositors’ savings for funding and long-term lending for earning. They earn the spread between short-term interest rates paid out to savers and long-term interest rates charged on borrowers. In this depositor-bank relationship, a bank is a borrower of deposited money; depositors are lenders to the bank. Although banks may appear to be the winners in the sense that they can charge on the deposit, the opposite may be true. Since depositors could withdraw deposits and hoard money at home to avoid subsidising their banks , banks could face a high chance of losing their source of funding and going out of business. Arguably, hoarders may win by appreciating the increase in the purchasing power of fiat money under deflation, free from negative interest charges at home; however, considering other factors such as security issues, it is not automatically clear. Needless to say, in the case of private lending transactions, banks, as lenders, would have no incentive to assume credit risk to lend if they are burdened by an extraordinary duty to pay periodic payments to borrowers.

Overall, under our contemporary fiat-money currency regime, there would seem to be no winners once negative interest rates penetrate into private lending and deposit rates. In this sense, for transactions on the street, nominal "private" interest rates are required to remain positive. In the world of fiat-money, negative interest rates, if applied generally on the street, could cause social unrest. What central bank would want to account for such a negative consequence that could lead to social unrest?

What would it be like if the world reformed the monetary system to be able to apply negative nominal interest rates without causing social unrest? What system would be appropriate to unbundle the “Zero Boundary” of nominal "private" interest rates? Whatever the alternative system would be, a reform in our “medium of exchange” system would be inevitable. One of the alternatives is to “digitise” and make the medium of exchange registered and traceable. (Buiter, 2009)

Nevertheless, an essential question arises: should it be operationally feasible, is it politically viable? Buiter's following remark addressed the political aspect of the monetary system.

“(Buiter) believes that the real reason behind the continued existence (of fiat-money) is the substantial seigniorage (by sovereign states) through the issuance of non-interest bearing and non-redeemable legal tender.” (Ilgmann & Menner, 2011)

Insofar as the monetary system is managed by our government, we cannot discuss the monetary system solely based on economic framework: it is a product of political endeavours. Inasmuch as our government takes control over our monetary medium, “registered & traceable digitised money” might be excluded from the realm of politically feasible solutions.

However, there is a new reality emerging. In order to contain corruption, India announced a drastic measure to abolish high-denomination bank notes. The public is still allowed to use credit cards and bank transfers for large transactions. This is one step toward digital money. There is speculation that other countries, such as Singapore and China, are considering the introduction of digital money to crack down on money laundering and corruption. How might it work out with political pressure from those corrupted?

Although it would be less fungible, there still remain other means for them to remain corrupted outside the reach of the government’s radar: quid pro quo. Among them, gold might be the most fungible means. This would mean, the black market would end up reintroducing metallic standard, “back to the antiquity.” The world might enter into multi-standard currency regime, if digital money is introduced.  

In summary, as of today, as long as our contemporary monetary system goes with the fiat-money, our convention postulates the zero-boundary for nominal "private" interest rates, with some exceptions on a limited scale, such as that of Riksbank. In other words, nominal "private" interest rates must remain positive.

More importantly, the notion of the zero boundary for nominal "private" interest rates might suggest an ineffectiveness of negative "policy" interest rates under the fiat-money regime. While central banks can impose negative "policy" rates on regulated banks at will, the impact of negative "policy" rates may not penetrate into private lending and deposit transactions to the extent they initially intended, due to the zero boundary.

[2] Impact on the Real Interest Rate:

In an environment of persistent deflation, the zero boundary of nominal "private" interest rates automatically locks the real "private" interest rate in the positive territory. A positive, real risk-free interest translates into a wealth transfer from borrowers to lenders. This would not disagree with the norm in a growing economy. In a growing economy, with many borrowers who are willing to take out new loans—wealth transfer from borrower to lender—would give economic incentive to lenders without destroying borrowers’ incentives excessively.

However, under a severe recessionary environment, positive real interest rates would be contractionary. To begin with, there are fewer borrowers who are willing or even qualified to take out loans. Positive real interest rates would simply exacerbate the situation by discouraging borrowers to take out new financing for consumption. Under economic contraction, monetary authority might well be inclined to manufacture negative real risk-free interest rates to induce borrowers to take out new credit for consumption. However, deflation, together with the zero boundary of "private" interest rates, confines real risk-free rates within the positive territory. Deflation strips away the margin of manoeuvre for a central bank to manufacture negative real risk-free rates.

Here is another example of why national governments usually dislike deflation. National governments in advanced economies have accumulated massive debt burdens. Naturally, they might be tempted to engineer “negative real interest rates” in order to technically reduce legacy debt burdens. Contrary to positive real interest rates, negative interest rates represent wealth transfer from lender to borrower: therefore, negative real interest rates become a technical instrument for debt liquidation without relying on the cash-generating capacity of borrowers (in this context, governments). Negative real interest rates, however, can be manufactured only under inflation. Inflation is a necessary condition, but not a sufficient one. The sufficient condition would be setting interest rates below the inflation rate. In a deflationary environment, the zero boundary sets in and refrains real interest rates from entering negative territory. Therefore, deflation would be enemy number one from a government debt perspective.

In addition, deflation would lead to more general confusion in economic perception, due to conflicting consequences between nominal and real rates. Under deflation, although nominal rates would continue to decline and appear cheap, the real rate would remain trapped in positive territory. A persistent deflationary environment would create a gap between nominal economic perception and real economic reality: in other words, it would create “money illusion.”

[3] Notes & Reminder

This section serves as a precautionary reminder for readers regarding the terms used in the discourse above. The subject of the article presented above—negative nominal interest rates—is different from negative yields, which can be deemed interchangeable with interest rates in the general context of bonds.

Yield conveys notions of both capital gain/loss as well as interest payment cash flow, and therefore represents a total return measure (strictly speaking, with a further assumption that the cash-flow, or coupon, can be reinvested at the same yield rate). Excess demand or a shortage of supply could lift the price of bonds to an extent to account for negative yields; deflation would not be required to cause a negative yield. For example, "flight to quality" in the materialisation of an extreme risk event can boost the demand for prime bonds and might account for negative yields. On the other hand, the nominal coupon rate only represents a rate that determines interest payment cash flow against the nominal principal, but does not reflect the capital gain/loss. In our discussion in this article, we refer to the latter "coupon" notion in terms of negative interest rates with a focus on saving transaction. The distinction here is not to go against the widely accepted custom, but to narrowly define the term for the sake of argument on this particular topic. In this section, the subject is strictly “nominal interest cashflow,” exclusive of “capital gain/loss.”

Overall, the zero boundary is a product of the fiat-money system and asymmetric structure of our contemporary monetary system. Throughout this article, the author intended neither to denounce nor advocate fiat money, but to attempt to characterise its potential implications in our contemporary economic reality.  

One of its alternatives, the metallic standard—such as the gold standard—was a far from perfect system. First, it posed a trilemma paradox, in which it is impossible to simultaneously satisfy three objectives: stable exchange rate, free capital flow, and independent monetary policy. Second, it incentivised military deployment for monetary purposes to gain control over the precious metal resources, e.g., Spanish conquistadors in South America and the Boer War. Fiat money is not perfect, of course. The prevalence of debt-management problems among advanced economies in the second decade of the 21st century reflect the systemic problems of the fiat-money system.

 Our history suggests one thing for sure: whatever monetary instrument is chosen—metallic standard or fiat money—there will be, without fail, violations of the underlying operating principles and abuses of the system by our governments. This is not an instrument problem, but a user problem.
Reference
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