Central Banks and the Perils of Sub-Zero Conditions
The longer such conditions persist, the greater the risk of perverse consequences
By Richard Barley
Feb. 18, 2015 5:37 a.m. ET
Stefan Ingves, governor of Sweden's central bank which last week cut its main interest rate into negative territory for the first time. Photo: Bloomberg News The monetary-policy anchor keeps on slipping.
Until recently, it was broadly thought that zero was the final frontier beyond which central banks wouldn’t or couldn’t cut interest rates.
But negative rates are now all the rage. The European Central Bank’s deposit rate is negative 0.2%, although its main refinancing rate remains just above zero. The Danish certificate of deposit rate is negative 0.75% in an effort to prevent the krone appreciating. The Swiss National Bank has gone negative to reduce the allure of the franc. The Swedish Riksbank has cut its key rate to negative 0.1% and says it could go further.
Even central bankers who aren’t cutting are thinking about the lower bound. The Bank of England is talking about raising rates. But it still explained last week that if needed, it thinks it could now cut rates below 0.5%, previously a limit it hadn’t wanted to breach for fear of damaging the banking system.
How strange are zero and negative rates? Bond markets are proving that financial math works just the same with negative yields, even if paying a borrower for the privilege of lending to it looks fundamentally odd. The Swedish Riksbank says that cutting rates below zero, at least if the cuts aren't very large, is expected to have similar effects to cuts when the rate is positive. Others go further:
Willem Buiter, Citigroup’s global chief economist and a former Bank of England monetary policy maker, said in a January note that an interest rate of minus 5% should be no harder to set than a positive rate of 5%.
But theory, as ever, can clash with reality. There is some real lower bound: the point at which it becomes rational to hold physical cash rather than putting money in the bank. That rate is below zero, as keeping large amounts of cash is risky, requiring storage, security and insurance.
But it isn’t clear how far below zero it is. There are ways around this, but they are radical: Mr. Buiter suggests abolishing currency as one route. Even with the rise of electronic payment systems, that seems unlikely to make it as a real-world policy option.
One thing to consider is how long negative rates might persist. Brief periods may be regarded as an anomaly. But over time, negative rates could change the behavior of savers and borrowers and the way they make use of the financial system. In a system that is basically set up to operate under positive nominal interest rates, that could be a problema.
More cuts could yet come. The Riksbank says it will be watching for the effect of its first cut as a factor in deciding how much further to go. Many expect further action from the Danish and Swiss central banks.
The upshot is that central bank policy is deep into experimental territory. Experiments can yield valuable insights, but they can also cause accidents.
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