Break on through (to the other side)

Now that we know the zero lower bound of interest rates isn’t, well, a bound at all, the question is where the floor actually is. Economics blogger Evan Soltas and David Keohane at The Financial Times both tried to figure out how negative nominal rates can get.

Basically, rates are only going to get negative if everyday people prefer cash-like instruments over cold hard currency. In the reckonings by Soltas and Keohane, negative rates arise when people prefer checking accounts over straight cash. When you can easily pay for a coffee with a debit card, checking accounts end up being more liquid than currency. So to break even, banks will only set interest rates as low as zero minus the cost of storing cash (about 1 percent) and convenience cost of liquidity (roughly 2 percent). So the lower bound’s about negative 3 percent in this telling.

Paul Krugman disagrees. At least in part:

Once interest rates on safe assets are zero or lower, however, liquidity has no opportunity cost; people will saturate themselves with it. That’s why we call it a liquidity trap! And what this means is that the marginal dollar of money holdings is being held solely as a store of value — the medium of exchange utility is irrelevant.

This in turn should mean that the usefulness of deposits is irrelevant in trying to find the true lower bound. The marginal holder is simply looking for a store of value, and the only question should therefore be storage costs.

In Krugman’s telling, the bound for interest rates is then zero minus the storage cost. Convenience costs don’t matter all in this case.

But is the cost of storage for the marginal borrower really the cost of storing cash? Consider the realities for a moment here: The Federal Deposit Insurance Corporation only insures up to $250,000 per depositor per bank. So large investors really don’t park their money in savings accounts. They use highly-rated bonds as their preferred safe store of wealth. Zoltan Pozsar, the director of Credit Suisse’s global strategy and research department, argues that the rise of large cash pools (sovereign wealth funds and corporate treasuries) necessitated the use of safe assets (highly rated debt) as stores of value.

The marginal holder of this debt is far more likely to be a large investor than a single person stashing money in a checking account, so it seems like the return on a safe asset is the storage cost. This in turn would mean there’s no bound at all. Interest rates will go as low as needed to clear the supply and demand for safe assets.

The reason why we have negative rates right now is because the supply of safe assets is already so small after years of unconventional monetary policy and austerity combined with increased demand for safe assets due to fears about economic slowdowns across the world. The supply was low enough already that this increase in demand took the price of the bond above the face value of the bond.

“Break on Through (to the Other Side)” takes on a whole new meaning when we find on the other side of the zero lower bound that there’s nothing to stop us from going even lower.