Experimenting with Negative Interest Rates

As the world’s original central bank, it’s fitting that Sweden’s Riksbank has become the first to breach the zero-bound line by lowering one of its key interest rates to negative 0.25% since July 8.

The drop in the price of money below zero is reportedly the first of its kind. The dip refutes the idea that the zero bound was a barrier for monetary policy beyond which no central bank could tread. Back in 2004, Fed Chairman Ben Bernanke (a Fed governor at the time) co-authored a research paper that advised that “the nominal policy interest rate may become constrained by the zero lower bound.”

Well, so much for a constraint at zero. The Riksbank dropped rates below zero in early July with no more effort than falling out of a chair. Granted, Sweden’s -0.25% deposit rate (the rate that banks receive on accounts held at the central bank) isn’t the main tool of monetary policy in the country. That’s reserved for the repo rate (the Riksbank’s Fed funds equivalent) and it remains at a positive 0.25%, or roughly in line with the current Fed funds rate. Nonetheless, the precedent has been set. Dropping rates below zero has come and gone in the modern age of central banking and the financial world is still standing. In practical terms, the Riksbank’s -0.25% deposit rate means that banks with accounts at the central bank are paying Riksbank 0.25% in interest to keep deposits at the institution. In effect, the arrangement turns the concept of a bank account on its head. Instead of earning interest, depositors are paying the bank to maintain the accounts.

The rationale for the policy is that the negative interest rate will create a disincentive to hoard money, which creates an additional layer of headwind for an economic recovery. In these precarious economic times, that’s considered a risk worth avoiding.

To be sure, there are hazards in going negative. For instance, as Wolfgang Münchau notes in today’s Financial Times, central bankers worry that 1) negative interest rates as a broadly used policy tool remain experimental with unknown consequences; 2) breaching the zero bound might destroy the money market business; 3) negative rates might inadvertently promote speculative activity above and beyond the normal incentives offered in the private sphere.

On the other hand, negative interest rates may be a potent weapon in combating deflation and otherwise promoting economic recovery in the face of an extraordinary economic contraction.

Rest assured, the Federal Reserve and other large central banks in the world are nowhere near the point of following in the Riksbank’s footsteps. That’s because there’s no need to drop rates below zero in the U.S. and elsewhere at the moment. The worst of the Great Recession seems to have passed. True, a number of major risks still threaten, starting with the prospect that the “recovery” will remain unusually tepid for an extended period. As a result, the possibility of another recessionary dip and/or deflation can’t be ruled out.

This much, however, is clear: the negative interest rate has officially become part of central banking’s arsenal. Although its application is currently limited to one institution, it’s not yet clear that this smallest of clubs won’t expand before the Great Recession formally becomes history.

Originally published at The Capital Spectator and reproduced here with the author’s permission.