A week or so back, at the Monetary Policy Statement press conference, veteran Herald economics journalist/columnist Brian Fallow asked the Governor about how well-situated New Zealand was to cope with the next recession, given how low the OCR is now (1.75 per cent, as compared with 8.25 per cent going into the previous recession).
As I recorded in a post the same day, the Governor and his offsiders responded with a degree of confidence that wasn’t backed by much substance. It all smacked of a worrying degree of complacency.
Fallow also apparently wasn’t persuaded, and returned to the issue in his weekly Herald column yesterday. I wanted to pick up today on just one of the topics he touched on in that column.
The key issue is the effective lower bound on nominal interest rates. The Reserve Bank has indicated that it believes the OCR probably couldn’t usefully be taken lower than -0.75 per cent (I agree with them, and that assessment of the effective lower bound is consistent with the lowest any other country has set its policy interest rate). Beyond that point, it seems likely that an increasing proportion of holders of short-term financial assets would transfer into holdings of physical cash. There is no direct cost of conversion, although there are storage and insurance costs for physical cash (which is why large scale conversion doesn’t occur at, say, -5 basis points).
When official interest rates were dropped below -0.75 per cent it still probably wouldn’t affect very much much (or how) little cash you hold in your wallet/purse. If you hold much cash at all, it is probably for convenience (or privacy), balanced against (say) risk of loss/theft. And a secure physical storage facility for even $10000 of cash would be much more inconvenient – and probably expensive – than holding a short-term bank deposit. You might well, grudgingly, live with an interest rate of -2.0 per cent per annum (as it is, since the last recession, marginal term deposit rates have been well above the OCR anyway). Or you might seek to shift your money to riskier (potentially higher-yielding assets) – in which case the lower policy interest rate would still be somewhat effective.
But the big issue here isn’t so much what the ordinary householder does. Most don’t have that many financial assets that could be converted directly to cash anyway. The bigger issue is institutional investors (resident and foreign, including – for example – Kiwisaver funds). The funds management market is pretty intensely competitive, and (risk-adjusted) yield-driven (as an example, I was in a meeting yesterday where we looked at a restructuring option to save perhaps 3 basis points). So if the Reserve Bank tried to cut the OCR to, say, -2.0 per cent (and it was expected to remain at least that low for a couple of years), there would be big incentives to find alternative assets yielding a less-negative (or positive) return. The most obvious example is physical cash. And if there are incentives for fund managers to find such alternative options, there are incentives for trusted operators to provide them (secure physical storage for large quantities of physical currency). Willing buyers and willing sellers usually find a way to get together, at least if regulators don’t come between them (in this case the regulator – the Reserve Bank – actually creates the problem. People sometimes talk about a lack of secure storage facilities, but $1 billion in $100 bills doesn’t take much space (nor, really, does $100 billion). (On US note dimensions, the calculations are here.) If conversions of this sort happened on a large scale, a lower OCR won’t have any material effect – other than encouraging remaining asser holders to convert to cash. It wouldn’t lower retail interest rates (much) and wouldn’t lower the exchange rate (much).
These sorts of conversions wouldn’t happen overnight. Probably most funds managers and the like won’t have physical cash in their list of approved assets. Some will be able to change that faster than others. Those that can will be able to offer better returns than those that don’t. And such conversions would be much more likely in the next recession precisely because the starting point – initial low interest rates – is so bad. It is quite likely that official rates could be negative for years. Or perhaps the conversions will just never happen because central banks (here the Reserve Bank) just don’t lower their official rates far enough to make conversion economic. But, if so. they will have made the point: conventional monetary policy will have very quickly exhausted its capacity.
And so various people, including me in the New Zealand context, have been arguing for some years now that something needs to be done – and needs to be done early, to condition expectations about the next recession – about the effective lower bound. Brian Fallow refers to this in his article
Overseas experience suggests that at most, a negative policy rate might move the effective lower bound for interest rates 75 basis points into the red. Moving it lower still would require, economist Michael Reddell suggests, imposing a fee on banks switching from virtual to physical cash.
It wouldn’t be difficult. There are more complex models on offer – see Miles Kimball or Citibank’s Willem Buiter – but the desired results looks to me to be able to achieved quite simply by setting a cap on the regular holdings of physical currency (say 10 per cent above current levels). It might need to be a seasonally adjusted cap (currency demand rises around Christmas and the summer holidays, and then falls back again). The cap would need to rise through time (currency demand rises with the size of the nominal economy). But the key point is that any net issuance beyond that level would be auctioned (perhaps fortnightly or monthly). Any creditworthy entity – the sort of institutions the Reserve Bank deals with routinely – could participate in the auctions, and the marginal exchange price between settlement cash and wholesale volumes of physical cash would then be established quite readily, and could alter through time. If the state of the economy and inflation meant the Reserve Bank needed to cut the OCR to -5 per cent (and in the US context, there are estimates that such a – temporary – rate would have been desirable in 2009), there would be a lot of demand for physical currency, and no more supply. The market-clearing price would rise, perhaps sharply.
Of course, banks supply currency to retail customers on demand, mostly through ATMs. Banks would be free to respond to the rise in the marginal cost of obtaining new notes by passing those costs onto customers (retail or wholesale). A (say) 5 per cent conversion cost of obtaining cash would encourage retail customers to economise on cash holdings (using EFTPOS etc instead), while allowing those who put most value on having physical currency to pay the price. These days very few domestic transactions strictly require much cash.
Perhaps there are pitfalls in such a scheme. If so, now is the time to be identifying them, not in the middle of the next serious recession. Now is the time to be socialising – including with the public – possible solutions, not in the middle of the next serious recession (when putting a premium price on physical currency suddenly announced might actually be seen as a negative signal about the soundness of banks – ie discouraging people from holding cash). Perhaps there even legislative obstacles – I’m not aware of any, but all sorts of obscure issues can arise when one looks into anything in depth. But, again, now is the time to identify those issues and fix them, not in the middle of the next serious recession. There would probably need to be an override mechanism to cope with a genuine financial crisis driven run to cash.
And if there are better, workable, models, now is the time to identify them, and to test the alternative models in open dialogue, to ensure things are easily pre-positioned to cope with the next serious downturn.
Unfortunately, there is no sign of any of this sort of preparation occurring. Certainly, nothing has been signalled by the Reserve Bank or by the Treasury or by the Minister of Finance. If they aren’t doing the work, it is (complacent) negligence. And if they are, but simply aren’t telling us, it would be quite unwise.
After all, as I noted in the earlier post, a key consideration the authorities need to be addressing is expectations (about inflation and policy). In a typical serious downturn, inflation expectations fall but not too much, as all market participants expect that the downturn will be relatively shortlived, partly because of aggressive cuts to official interest rates. But going into the next recession – whenever it happens – it seems increasingly likely that few central banks will have the interest rate adjustment capacity they would like. And all economists and market participants will recognise the constraint, and are likely to factor it into their expectations are seen as a downturn in underway. A rational response would be to cut inflation expectations (actual or implicit) much more sharply than usual – in turn, driving up real interest rates (for any given nominal rate), worsening the downturn, and worsening the reduction in inflation. This issue doesn’t seem to get the attention it deserves even in the international discussions of these lower bound issues, but it looks to me like a pretty straightforward implication of the current situation.
Since none of us knows when the next severe recession will hit – it could be years hence, but it could be next year – this isn’t the time to let the issue drift. Too many people paid the (unemployment) price of central bankers reaching their limits last time around to contemplate with equanimity going into the next recession starting from a situation where current low official interest rates are still only consistent with inflation at or below target in most countries, including New Zealand. Dealing with the lower bound issue should be treated a matter of urgency.
(For those who are quite relaxed because of fiscal policy options, I might do a post next week on why it shouldn’t be very much consolation at all.)