Stop before things get out of hand. That was the subtext of the Swedish central bank’s explanation for its intention to increase the policy interest rate in December, from minus 0.25% to zero. Going ahead with that plan would keep the Riksbank in the vanguard of central banking.
The Swedes were pioneers of negative rate thinking. The central bank reduced its deposit rate for excess reserves to minus 0.25% in 2009. Since then, many others in the developed world have taken the plunge. Indeed, the Riksbank’s plan to increase its repo rate goes against the revised conventional wisdom among monetary economists.
In their view, the stimulative effects of lower interest rates are the same whether the rate goes from 3% to 1% or from 1% to minus 1%. These theoreticians think in so-called real terms, which take inflation into account. Real interest rates were negative through much of the high-inflation era of the 1970s. While a negative nominal number might be necessary now, when inflation rates are low, the difference is merely technical, in their view.
This real-rates theory was long treated as unrealistic. Sceptics argued that people would rather keep cash in safes than lend money, if they knew they would be repaid fewer dollars or Swedish crowns than they provided. Most policymakers had therefore assumed that zero was a “lower bound”. Below that, there be dragons, as navigators of yore used to say of uncharted waters.
Pioneers like Sweden showed that negative-rate seas were actually quite calm. Safes have their own costs and money is flowing freely into negative-yielding bonds. At last count, there were $17 trillion worth of negative-yield government debt outstanding, equivalent to about 20% of the world’s GDP.
However, there are two reasons for the Swedes to revert to something closer to the old stay-positive orthodoxy. The central bank alluded to one in its October monetary policy report, which said that people’s behaviour might change, and negative effects could arise if negative nominal interest rates were perceived to be a relatively permanent condition.
As Claudio Borio of the Bank for International Settlements points out, give away credit easily leads to reckless borrowing, which leads to financial bubbles. When they pop, there are financial crises, which create economic troubles. In the Scandinavian property crash of the early 1990s, Swedish commercial property prices fell by two-thirds and GDP dropped by 5% over three years.
A quarter percentage point rate rise will not be enough on its own to forestall this sort of disaster. But in a country where the domestic housing market is overheated, the move will signal to lenders that the central bank is worried by a 20-year trend of rising household indebtedness, from 120% to 180% of household income.
The second reason to move up to zero is that the current monetary theory may be flawed. The central bank can impose negative rates on banks, but lenders are generally reluctant to do the same to their retail clients. That squeezes their profit margin. In response, they can lower lending standards in search of higher margins, for example by extending mortgage maturities, or simply shrink their businesses. Neither is desirable.
Markus Brunnermeier, an economist at Princeton University, says that rate decreases below a “reversal interest rate” actually hinders business activity. He believes this reversal rate creeps up the longer that rates stay low, because there are dwindling capital gains from long-term loans made earlier at higher rates.
Put together, the two anti-negative arguments are compelling. And Sweden is well placed to experiment with a return to zero. Not only does the Riksbank have a record of intellectual openness, but there are few worries that such a small move will push the currency to uncomfortably high levels. On a trade-weighted basis, the crown has fallen by 25% since 2013.
The Swedes might be more reluctant about ending negative rates if the policy was obviously helping the economy or pushing up inflation. But negative rates have not done wonders for economic growth, which remains tepid. The central bank’s October report painted a picture of a weak national economy, a weak global economy, and low inflation. Besides, the United State and UK have not been clearly hurt by keeping their policy rates positive.
Stockholm was a leader in trying out negative rates. If its latest experiment does no obvious harm, it may also embolden others to exit sub-zero territory.