Below zero August 18, 2012 at 2:11 pm
An interesting observation from the Bond Vigilantes, which moreover has implications for interest rate models that are floored at zero:
As investors we get used to living within certain recognised bounds. For example, it has been commonly assumed that interest rates cannot be sub-zero. There has been the odd historical quirk when we’ve seen negative rates (Switzerland in the 1970s), but that’s more for amusement than general investment consumption. However, there now appears to be the potential for a major investment climate change… Theoretically, a negative interest rate sounds simple – you put £100 in the bank and you get £99 back a year later if the rate is -1%. A rational investor would of course have the alternative of simply keeping their cash under the mattress and not suffering the negative rate, although the incentive to behave rationally would be limited by the administrative burden and security risk of holding cash. The central bank could simply limit this activity by basically not printing enough cash. Therefore the vast majority of money would have to be held electronically and could therefore suffer a penal negative rate. Implementation of sub zero rates is possible.
Their point about the mechanics of negative rates is interesting; absent enough hard cash for investors who wish to hold it, it’s easy to implement negative rates. One does rather wonder what would happen if a lot of cash was tied up under beds though; would the relevant central bank find themselves pressured by cash liquidity issues into printing (somewhat) more cash, much of which would immediately disappear from circulation?