With interest rates in negative territory and quantitative easing having run its course, central bankers are running out of options when it comes to promoting economic growth and stability using conventional monetary policy instruments.
That could explain why some central banks are looking at central-bank-issued digital currencies as an alternative monetary policy instrument. In July this year, the Bank of England published a staff working paper that outlined the macroeconomic implications of a CBDC.
The proposed benefits of a CBDC could include lower risk premiums, more liquidity in people’s pockets and greater competition for bank deposits, which may encourage commercial banks to offer higher interest rates relative to central bank policy rates. According to research conducted by the Bank of England, which saw an initial stock of CBDC equal to 30% of GDP issued against the same amount of government debt and then subjected to “countercyclical variations,” a CBDC could contribute to a 2.9% rise in domestic GDP.
In its working paper, the Bank of England states that a CBDC could act as a second monetary policy instrument that helps guard against shocks in the financial system. The distributed ledger that underpins digital currencies could also give central banks access to transaction-level data in real time, enabling them to better respond to crises.
The Bank of England is also reported to be working with researchers from University College London to develop a more secure digital currency that is unable to be counterfeited or tampered with.
But if a CBDC is to get off the ground, it cannot fluctuate wildly in value as bitcoin currently does. It would also need to be based on a permissioned system where transactions are validated and processed by known participants or a centralized body in a ledger system. Bitcoin is based on a permissionless ledger.
Research conducted by DnB, which analyzed the exchange rates of virtual currencies, suggests that the more virtual currencies are used by consumers and merchants for transactions and services, the less volatile is their value.
“A high level of volatility is a childhood disease,” stated Wilko Bolt from DnB’s economics and research division and author of the research. Bolt revealed his research findings at Imperial College Business School’s Center for Global Finance and Technology Fintech Conference in London in October.
More studies, however, are likely to be needed before central banks feel comfortable turning what are still largely theoretical concepts, into reality. Despite the many upsides, transitioning to a different monetary or financial regime based on a CBDC could also introduce risks.
One potential risk is that if consumers are able to hold deposits in digital currencies at central banks, it could create a funding problem for commercial bank deposits. Central banks would also need to consider how a CBDC might compete with other digital currencies like bitcoin, and who it would be issued to—banks, nonbank financial institutions, households.