(Bloomberg) – Canada’s central bank on Monday said financial markets could function even if policy interest rates needed to fall to negative 0.5 percent, citing the success with recent extraordinary policies used in Europe and Japan.
The Bank of Canada’s Review collection of research papers also said that most countries have been able to deploy those policies without a major overhaul of their inflation-targeting frameworks, a key consideration as the Ottawa-based institution is looking to renew its 2 percent target this year.
The international experience with unconventional policies has been “largely positive” even as there is evidence that the power of negative rates may fade over time, according to work by staff economists. The Bank said the conclusions in the research papers don’t necessarily reflect the official views of its Governing Council, which makes policy interest rate decisions.
Governor Stephen Poloz last year laid out some clues about what was held in today’s research saying the “effective lower bound” for interest rates was negative 0.5 percent, rather than its prior estimate of 0.25 percent. Poloz has said the bar is high for any overhaul of the inflation targeting system, citing its success over the past few decades. Below are some key passages from the Review papers, starting with how negative rates would work.
On savings accounts:
For savings accounts, people may choose to avoid negative interest rates by storing cash and paying fees for safe boxes and insurance. The bank incorporates the costs of such measures into its estimate of the effective lower bound:
“It has long been accepted that, in practical terms, nominal interest rates cannot fall below zero because investors can always earn a zero nominal return simply by holding cash.”
“When insurance requirements are taken into account, cash storage costs for the $100 denomination, for example, can be up to 35 bps per year.”
“Combining both the costs of holding and using cash, we estimate that the effective lower bound in Canada is likely between -25 basis points and -75 basis points, with a midpoint estimate of -50 basis points.”
On money-market mutual funds:
“The immediate response of many euro-denominated MMMFs to negative rates was to waive their expense fees and absorb the losses rather than passing them on to their investors.”
“MMMFs are a relatively small part of the financial system, and the impact of any potential disruption in this sector on the functioning of the financial system as a whole would therefore be limited.”
On floating rate notes:
European markets have set higher prices on bond sales, giving more room on the floating rate coupons to make sure there is little chance they will fall below zero, the bank said, and therefore: “It is not inconceivable that Canadian FRN issuers may also respond to negative rates in a similar way.”