Ben Dyson and Jack Meaning
A “Central Bank Digital Currency” (CBDC) may sound like it’s from the future, but it’s something that many central banks are researching today, including those in Sweden, Canada, Denmark, China, and the European Central Bank and Bank of International Settlements (BIS). In a new working paper, we set aside questions about the technological, regulatory and legal aspects of central bank digital currency, and instead explore the underlying economics. Could the existence of a CBDC make it easier or harder for central banks to guide the economy through monetary policy? And could the existence of CBDC make the monetary transmission mechanism (MTM) faster or slower, stronger or weaker?
We define CBDC in general as “any electronic, fiat, liability of a central bank that can be used to settle payments or as a store of value.” Specific design choices will determine the impact of CBDC on monetary policy and financial stability. In our paper, we consider a particular design of CBDC that is:
- universally accessible (anyone can hold it)
- interest-bearing (with a variable rate of interest)
- exchangeable for banknotes and central bank reserves at par (i.e. one-for-one)
- based on accounts linked to real-world identities (not anonymous tokens)
- withdrawable from your bank accounts (in the same way that you can withdraw banknotes)
As others have discussed, if CBDC only served as an alternative to paper or polymer bank notes – for example, as a kind of non-interest bearing ‘e-cash’ like the e-krona being considered by the Swedish Riksbank – the monetary policy implications are negligible. But the design of CBDC outlined above would pay interest on balances as well as offering payments services and would therefore compete more closely with bank deposits. This means there will be an impact on the volume and price of bank funding, with implications for monetary policy. However, in our design, CBDC accounts would not provide credit facilities, such as overdrafts, to the vast majority of users, which is one reason they would not be perfect substitutes for bank deposits.
MTM stage 1: the central bank sets the policy rate
The interest rate on central bank money is the starting point for traditional monetary policy. A key observation of our paper is that the rate of interest that the central bank pays on CBDC would act as a floor to all other rates in the economy. This is because it would both represent the safest store of value and also provide transactional services, so, in our model, no-one would lend to someone else, at risk, for less than they could earn by holding risk-free CBDC at the central bank. This would be in contrast to the historic norm, where deposit rates with commercial banks were typically below the policy rate. Other rates in the economy would then be above this CBDC rate, with the spread determined by factors like their relative transactional service, liquidity and risk. By varying the interest rate paid on CBDC, the central bank could move these other rates in the economy, either encouraging or restricting growth.
MTM stage 2: the policy rate feeds through to wider rates
Universally-accessible CBDC would represent an alternative option to bank deposits for those wanting to hold transactional balances risk-free. In our paper, this would mean that if any increase in the rate paid on CBDC were not matched by an equal increase in the rate paid on deposits, some people would move their deposit balances to CBDC. (This would happen in the opposite direction when CBDC rates fell.) Banks would therefore need to react more quickly to changes in central bank policy rates, in order to avoid losing deposits to CBDC accounts. This would result in an increase in both the strength and speed of pass-through from the policy rate to these other interest rates, especially as technology and regulatory changes make it easier to switch balances from one account to another.
However, banks may respond to the risk of losing deposits by switching their funding from instant-access ‘demand deposits’ (such as current accounts and instant access savings accounts) to longer-term ‘time deposits’ which have either a notice period or a maturity date. This would mean that even if the central bank changed the CBDC rate, it would take more time for these changes to be applied to the stock of deposits. This could partially slow down the speed of transmission of monetary policy changes.
MTM Stage 3: Transmission to the Real Economy
There are a number of channels through which the change in wider market rates feed through into changes in the real (non-financial) economy, but it is those channels that operate through the banking sector that are most likely to be affected by the introduction of CBDC. As discussed above, the funding costs of banks in our model then become more sensitive to changes in policy rates. All else equal, this would directly drive an increased sensitivity of lending rates to policy changes – interest rates on mortgages, loans and credit cards would move by more for the same change in the policy rate. What is more, the ability of non-bank lenders to clear transactions across the central bank’s balance sheet, rather than relying on their competitors in the banking sector for ultimate access, would increase competition in lending, further increasing pass-through to lending rates.
All taken together, we believe the CBDC we analyse would increase the strength of the monetary transmission mechanism. However, it is difficult to make precise quantitative estimates for the simple reason that no equivalent to CBDC currently exists, and so it is unclear how much demand there would be for it, or how that demand would be affected by the specific design of CBDC.
A different way to do Quantitative Easing
When central banks do quantitative easing, they buy financial assets (usually government bonds) from the non-bank financial sector, such as pension funds, in exchange for newly issued reserves. However, the central bank does not generally pay non-banks directly, because non-banks cannot hold accounts at the central bank. Instead, the central bank uses banks as intermediaries: it pays reserves to the pension fund’s commercial bank, and the commercial bank creates new deposits and credits them to the pension fund’s account. This means that expansion of the money supply through QE necessarily results in the banking sector holding more reserves, in aggregate.
Using the banks as an intermediary has side effects, such as forcing banks to hold more liquid assets than they would like. They may react to this by selling other liquid assets, such as government bonds, which would act as an offset to the central bank’s quantitative easing. We show in our paper how, with a universally accessible CBDC, this would not be the case. The central bank could pay for assets from non-banks directly with central bank money (CBDC), by-passing the banking sector altogether.
Alternative policy options
Our paper focusses on the impact of CBDC on existing policy instruments: the short-term interest rate and QE. However, there is a debate around how CBDC may impact on a wider, less orthodox range of policy options. For example, advocates of negative interest rates often suggest that abolishing cash would help to remove the ‘zero lower bound’ that currently limits how low rates can go (because if deposit rates turn negative, people can always switch to physical cash, which effectively pays 0%). Whilst abolishing cash is not seriously being considered by any central bank, Andy Haldane has suggested that in theory, a CBDC could meet the public’s demand for central bank money even if physical cash were abolished in order to impose negative interest rates. Miles Kimball and others have even suggested a way CBDC can be used to implement negative rates without the need to abolish cash. Another proposal is the use of ‘helicopter money’ – direct distributions of newly issued money to citizens, to provide a stimulus to spending. These policies do not necessarily require a CBDC, but the existence of one could have material consequences for their implementation and efficacy.
Our early work suggests that a CBDC that is a close – but not perfect – substitute for bank deposits may strengthen the transmission of monetary policy changes to the real economy. It could also make quantitative easing slightly more effective, by by-passing the banking sector and avoiding some unwanted side-effects. Although there are many significant questions still to be explored, such as the impact on financial stability, on the central bank’s balance sheet, and on the monetary framework more widely, this paper contributes to the growing understanding of CBDC by showing that, with careful design choices, a CBDC need not be disruptive to the conduct of monetary policy.
Jack Meaning works in the Bank’s Research Hub and Ben Dyson works in the Bank’s Note Operations Division
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