Could interest rates in Canada go below zero?

par Andrew Rickard | May 19 2016 01:48PM

It used to be believed that interest rates could not go below zero because investors would simply withdraw their funds and hold cash. However, a recent study from the Bank of Canada notes that interest rates have actually turned negative in Sweden, Denmark, Switzerland, the euro area, and Japan. It examines what an effective lower bound (ELB) might look like in Canada.

In Estimating Canada’s Effective Lower Bound, authors Jonathan Witmer and Jing Yang from the Bank of Canada's Financial Markets Department explain that there is a cost to holding cash, especially in large quantities. When insurance requirements are taken into account, they suggest that annual storage fees come to about $3.50 per $1,000 held in cash. The cost of storing precious metals would be similar, or higher in some cases such as silver (which would take up more space than the same value stored in gold). Precious metal backed exchange-traded funds (ETFs) may benefit from scale, but they too would still have to pay 20 to 45 bps for insurance and storage, and there would be fund management fees and expenses on top of this amount.

Convenience value

Finally, there is the question of convenience. In order to avoid the hassle of sending cash payments and retain the ability to make payments electronically, the authors believe that bank customers (corporate customers in particular) would be willing to accept a small negative return on their deposits rather than switch to cash. They calculate this convenience value to be between 0 and 25 bps. "Combining both the costs of holding and using cash, we estimate that the ELB in Canada is likely between -25 bps and -75 bps, with a midpoint estimate of -50 bps," conclude Witmer and Yang. 

The study goes on to consider how negative interest rates might affect the transmission of monetary policy. It notes that banks in countries with negative interest rates have been reluctant to pass on negative rates to their retail depositors, which limits the extent to which banks can reduce their lending rates without sacrificing profitability. The authors also point to a recent survey which suggests that many depositors would withdraw their deposits from banks or change their saving habits when faced with negative rates. However, they argue there is evidence that monetary policy in other countries with negative rates is indeed being transmitted to long term benchmark yields.

Experience in Europe

"We do not know with certainty where the ELB for the Bank of Canada policy rate is, nor do we know precisely how long it could stay negative without causing disruptions to the financial system or a surge in the demand for cash. We do know that the ELB in Canada is lower than the earlier estimate of 25 basis points," concludes the report. "Based on our analysis of international experience as well as the costs of holding and using cash, and taking into account Canadian market circumstances, our current best estimate is between -25 bps and -75 bps, with a median estimate of -50 bps. The experience in Europe demonstrates that markets have adapted reasonably well to the challenges associated with negative interest rates."