The Future of Inflation Part III: The Electronic Money Standard and the Possibility of a Zero Inflation Target

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Bibliographic details

• Authors: RUCHIR AGARWAL, MILES KIMBALL
• Published: April 12, 2022

Overview and core argument

• Transitioning to an “electronic money standard” can make a world with lower inflation (and even zero inflation) and no persistent recessions possible by eliminating the zero lower bound.
• Eliminating the zero lower bound empowers central banks to quickly restore full employment and, over the medium term, possibly move toward targeting full price stability with zero inflation.
• Breaking the zero lower bound requires removing the arbitrage between paper currency (cash) that guarantees a zero nominal interest rate and electronic money that could bear negative rates.

Why central banks set about a 2 percent target

• A long-term inflation target of 2 percent or more reflects, in part, the danger posed by zero lower bounds.
• Before zero lower bounds constrained policy, advanced economy central banks typically cut nominal rates by 5 to 6 percentage points to restore output to full potential.
• Declines in the “natural” real rate of interest (driven by factors such as an aging population raising the saving rate and lower productivity growth) have lowered nominal policy rates for a given expected inflation.
• The slide in nominal interest rates made zero lower bounds serious obstacles; during the Great Recession many policy rates were cut to near zero and kept there for years, with only a few economies venturing into mildly negative territory.
• Central banks worry that lowering their inflation target while a zero lower bound remains would be risky for credibility; ability to rely on negative rates (as noted for the Bank of Canada) affects inflation-target decisions.

The electronic money standard: definitions and mechanics

• “Electronic money” is defined as money instantiated as an entry in a bank’s computer, including checks, credit cards, and debit cards.
• The “electronic money standard” is the alternative to the current “paper standard.”
• Two policy elements to break the zero lower bound:

1. Adopting or strengthening an electronic money standard in which electronic money is the unit of account. 2. Implementing a time-varying interest rate (or more generally, rate of return) on paper currency (cash) so cash’s return moves with official policy rates, eliminating arbitrage.

• Operational change can be done while remaining close to the current monetary system, but legal, communication, and political challenges exist.
• Eliminating cash is not required; modifying paper currency policy or introducing fees/limits at the central bank “cash window” can prevent arbitrage profits and allow deep negative rates.
• Altering cash window policies can be implemented within weeks; full elimination of cash would likely take decades and be politically controversial.

Benefits of transitioning to an electronic money standard and lowering inflation toward zero

• Benefit #1: True price stability with restored firepower to end recessions
  • Eliminating the zero lower bound allows central banks to enable deep negative rates when needed, restoring monetary policy’s power to end recessions quickly.
  • Returning to traditional interest rate policy avoids side effects of quantitative easing and does not add to the national debt.
  • Monetary policy using interest rates allows fiscal policy to focus on long-term structural challenges.
• Benefit #2: Avoid episodes of high inflation by enabling vigorous use of interest rates in either direction
  • Reliance on forward guidance rather than negative interest rate policy tied some central banks’ hands during recent shocks, contributing to sluggish policy response to record-high inflation.
• Benefit #3: Minimized nominal illusion
  • Zero inflation minimizes “money illusion” because average nominal rates will equal real rates once inflation expectations adjust.
  • Inflation in terms of paper currency is relatively harmless if the electronic unit of account has zero inflation; paper currency policy can match returns to policy rates.
• Benefit #4: A simple price-level-targeting approach
  • A zero inflation target simplifies price-level targeting communication: return to the previous level of prices.
  • With zero inflation, price-level targeting is easier to explain and implement than under positive inflation where “catch-up” or “catch-down” dynamics complicate messaging.
• The authors predict that if the zero lower bound is broken, many central banks will eventually choose to target inflation rates of zero.

Complementary tools and design considerations

• Subsidies:
  • Use of the interest-on-reserves formula to subsidize zero rates on small deposit accounts to protect small depositors and insulate banks’ profitability.
• Macroprudential measures:
  • Lower rates facilitate increased capital requirements and tougher macroprudential measures without aggregate demand costs.
  • Suggested measures include raising capital requirements and imposing stricter amortization requirements to mitigate risks of bubbles, Ponzi schemes, or zombie firms.
• Measures to overcome downward wage stickiness:
  • Create incentives for firms to pay a substantial fraction of compensation as variable bonuses so nominal wages can adjust more flexibly.
  • Once zero lower bounds are broken, vigorous interest rate cuts can shorten recessions and reduce the problems caused by downward sticky nominal wages.
• Central bank digital currencies (CBDCs) caution:
  • To avoid a “digital zero lower bound,” a CBDC intended to help break the zero lower bound must be interest-bearing with the possibility of bearing negative rates.
  • Non-interest-bearing CBDCs are merely digital cash and would preserve a binding digital zero lower bound with large welfare consequences.

Policy implications and transition considerations

• Moving from a paper standard to an electronic money standard can empower monetary policy to cut interest rates sufficiently during recessions while enabling a gradual shift to a zero inflation target.
• Political, legal, and communication challenges must be managed; articulating a long-term goal of a cashless economy can help navigate politics, though an electronic money standard with cash remaining in a peripheral role may persist as a compromise.
• Trends supporting the shift include central bankers’ experience with mildly negative rates, progress in CBDC work (if appropriately designed), the rise of digital transactions and online marketplaces, and virtual work practices.

Source: F&D Magazine article “The Electronic Money Standard and the Possibility of a Zero Inflation Target,” RUCHIR AGARWAL and MILES KIMBALL, Published on April 7, 2022.