Do interest rates really stop at zero?

It is widely accepted that there is a 'zero bound' on interest rates and that this is a limit on the tool of monetary policy. But is this actually the case?

Denmark's central bank has cut deposit rates to minus 0.2% and there are suggestions that other Scandinavian countries may follow suit. If they can do it, why can't others? If the rate can be minus 0.2%, why can't it be minus 2%?

Such an outcome would certainly throw some basic assumptions on their head. I would be re-thinking my comment in a recent article that there is more downside than upside in fixed interest. And bank share prices might have a huge amount of blue sky that hasn't been priced in.

It would be an odd world. You could be paid to borrow money (although credit margins may rise so that borrowing rates stay positive) and physical currency would become economically preferable to deposits. But 'odd' doesn't make it impossible and, given the primary objective of monetary policy is to produce inflation, and how politically important such a result is, to some degree it seems a little odd that Governments would let a little thing like 'zero' stand in their way.

The following post, by Fed Reserve Bank of NY employees, highlights some of the difficulties that would arise from negative interest rates but they really aren't insurmountable. The major problem is supposedly the economic incentive to hold 'zero interest' currency. Where would we get enough bank notes? What about the security risks and practical hassles of having millions of dollars in notes being transported around?

The 'currency incentive' could be dealt with. Notes could be dated and depreciated the longer they are in circulation. A $1 note issued today could have a cent taken off its value annually, so that it could only be exchanged for 99c of notes issued a year later.

Surely Ben Bernanke and his European counterparts must have considered (or be considering) the negative interest rate solution. If they have, and they are as keen as they appear to be to prevent all that horrible saving and de-leveraging going on, it must be very tempting for them to find a way to pull the negative interest rate trigger.

The problem they face of course is that, whilst they can economically compel people to spend, controlling what they spend it on is a lot more difficult. Rather than the practical difficulties of having to find a way to issue $1 million bills, or rejigging bank systems so that people can be paid on home loans, is it really this threat, especially the risk that people will ditch dollars altogether, that will ensure the zero bound remains in place?

The Ben Bernanke's may want people to pull out the credit cards and buy shiny new houses, electrical goods and motor vehicles but the risk is they buy gold, silver and commodities.

Fortunately in Australia we have a long way (well, 3.5%) to run until we need to worry about the issue. I raise it as 'food for thought'. Also, whilst rates just below zero are clearly a possibility, I don't think we will see overseas central banks push them too much further due to fear of losing control of the money supply altogether. But, as the European saga continues to unfold, you just never know. Borrowing Euros, with a floating interest rate, might have a lot more upside than we give it credit for.