Central banks can adapt to life below zero

The zero lower bound is one of the great myths of monetary economics. It is the statement that interest rates cannot fall below zero, for otherwise people would hoard cash. Generations of central bankers have treated it as the equivalent of zero degrees Kelvin, the lowest theoretically possible temperature.

The Swedish Riksbank last week took the unusual step for a central bank of breaching the zero bound when it set a small negative deposit rate. The decision raises two questions. Should it be done? Can it be done? The answer to both is yes.

It should be done simply because real interest rates are presently not consistent with most central banks' inflation or price stability targets. Inflation is very likely to undershoot official inflation targets for some time to come. The reason is that interest rates are too high, because central banks feel trapped by an imaginary zero lower bound.

This brings us to the second and harder question. Can it be done, given the problem of cash hoarding?

First, modern central banks have more than one interest rate at their disposal. The Riksbank did not cut all its interest rates to below zero, only the deposit rate - the rate banks receive for their deposits with the central bank. The idea of a negative deposit rate is to discourage banks to hoard their surplus liquidity in the form of central bank deposits, as opposed to lending it to customers. By cutting only the deposit rate below zero, the Riksbank only partially transgressed the zero lower bound. It used negative interest rates for the purpose of a highly targeted operation. Negative interest rates are therefore not an all-or-nothing proposition.

Second, even if we accept the existence of a lower bound, it might not be zero. The traditional argument for the zero bound is that people simply move out of deposits into cash. But they have to store the cash somewhere and to protect it. This costs money. A US central banker once told me his estimate for the actual storage cost was somewhere between 1 and 2 per cent of the cash value. This means that negative interest rates of minus 1 or 2 per cent would probably not trigger a serious dash for cash. At those rates, people and banks would still prefer to hold their surplus cash in deposits rather than take the trouble to put it under a mattress and hire round-the-clock security guards. The storage costs still imply a lower bound, but one below zero.

Third, central banks could deploy policies to discourage cash hoarding. One extreme possibility would be to stamp cash, putting an expiry date on banknotes that would force their holders to pay a fee equivalent to the negative interest rates. Given the two previous arguments, this is probably not necessary, as the current economic situation does not require interest rates to be extremely negative. But it is good to know that such policies exist and can be deployed when necessary.

So why do central banks remain in awe of the zero bound? There are several explanations. The first is that central bankers are a risk-averse lot and do not like to tread where no one has gone before. It takes a small central bank such as the Riksbank to take the first step. Furthermore, it is no accident that Lars Svensson, the deputy governor of the Riksbank, who pushed hard for this policy change, is also one of the world's best known monetary economists. Academics are generally less troubled by the notion of a negative interest rate than practitioners, who tend to be overawed by technical arguments. I have heard the case made that computers would probably not be able to cope with negative interest rates.

Some central bankers have also argued that negative interest rates would kill the business model of money market funds. While that may be true, it is astonishing that its advocates prioritise the welfare of individual fund managers and their clients over the general goal of price stability. This is the argument of central bankers whose function is reduced to financial centre lobbyists.

A third argument is that zero or negative interest rates might lure investors into purchasing risky assets, in the full knowledge that those policies will sooner or later have to be reversed once the economy recovers. The latter is really an argument for a non-activist monetary policy, the kind that is generally preferred in continental Europe. But if non-activist policies result in large swings in inflation rates, they, too, might produce financial instability and unfair wealth distribution. So it is generally best for central banks to set interest rates to stabilise inflation expectations around a desired level, even if that requires vigorous policy action at times.

But there is one prerequisite for any such policy to be credible and successful, and this is my main ground for concern: the central bank must act symmetrically. When the economy recovers and inflationary pressures build up, central banks must raise interest rates just as vigorously. So if you believe that interest rates should be negative now, you should also accept that they might be strongly positive in a few years' time. While I have full confidence in the Riksbank, I doubt whether all central banks will have the nerve.

munchau@eurointelligence.com

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