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For years, central bankers have treated the fabled interest rate known as the “zero lower bound” as if it were a physical barrier.
Like the notion that temperatures cannot fall below absolute zero, policy makers thought they could not impose negative borrowing costs, as depositors would simply withdraw their money and hoard the cash.
However, as the risk of deflation has pushed central banks in the eurozone, Denmark, Sweden and Switzerland to venture below zero, the question has shifted from whether negative rates are possible to how low they can go.
Critics fear the unprecedented experiment of negative rates could have unwarranted side effects, including the formation of asset bubbles and deep disruption to the operation of the banking system.
“Negative rates are the policy for which we know least,” said Lucrezia Reichlin, an economist at London Business School. “They may create distortions and have undesirable distributional effects, so they should be considered an emergency, temporary measure.”
Denmark’s Nationalbanken was the first central bank in Europe to experiment properly with negative rates after the global financial crisis. In July 2012, the DNB began charging lenders 0.2 per cent for some of the cash parked in its deposit facility — a measure needed to defend the longstanding peg between the krone and euro.
But this experiment acquired a whole different scale at the start of the year, when the ECB launched a programme of quantitative easing, having already cut its deposit rate to -0.2 per cent. This forced neighbouring central banks to slash their own rates deep into negative territory to stem the risk of large-scale capital inflows.
In January, Switzerland dropped its deposit rate to as low as -0.75 per cent, while Sweden’s Riksbank moved its main repo rate to -0.25 per cent in March. The DNB, which had briefly raised the deposit rate back into positive territory, is now charging banks 0.75 per cent for their excess reserves.
Economists say that the possibility of negative rates arises because there are costs to storing and insuring cash. Savers will continue to keep their money in a deposit so long as this costs less than moving it into a safe.
In fact, depositors may be willing to pay even more than that, as it is far easier to handle money from a bank account than it is from a vault.
“What this comes down to is when people turn to barter,” said Marvin Barth, European head of foreign exchange strategy at Barclays. “What you want to know is the convenience value of money. How convenient is it to hold something that allows multilateral exchange?”
Mr Barth believes that interchange fees, which credit card companies charge to merchants and users, can offer some guidance on how convenient money is. “Interchange fees are on average 2-3 per cent, so negative rates of about 2-3 per cent are clearly feasible”.
While central bankers charging negative rates may have the economics on their side, there are political limits to how low they can go. So far, central banks have only charged banks for a portion of their reserves, allowing them to shield retail depositors from the fee. But the higher the charge, the less willing banks will be to spare their smaller customers.
“No central bank wants to be the first institution to impose a new tax on its citizens,” said Mr Barth.
In practice, the question of how much deeper interest rates need to be cut hinges on the effectiveness of existing measures in resuming growth and lifting inflation.
The outlook across the continent, however, is far from uniform. In Denmark, where the DNB’s monetary policy is aimed at preserving the peg between the krone and the euro, negative rates appear to have worked.
“The policy has been a success, and there is no reason to believe the interest rate will go lower,” said Steen Bocian, chief economist at Danske Bank. “The central question is when the central bank will start to normalise interest rates, and our prediction is that it will do so over the next three to six months”.
Across the Øresund Bridge, Sweden faces a tougher task. Consumer price inflation climbed back into positive territory in May, rising to 0.1 per cent from -0.2 per cent in April, but analysts believe the Riksbank may have to take further steps to revive growth.
“Given that inflation is slightly above the Riksbank’s forecast, further action is unlikely at the July meeting,” said Johan Javeus, chief strategist at SEB. “However, as the Riksbank has a very optimistic forecast for inflation in the second half of the year . . . they may still have to do more.”
A similar challenge faces the Swiss National Bank, which resumed buying foreign currency this year in an attempt to weaken the Swiss franc, boost exporters and lift inflation from its rate of -1.2 per cent.
“Inflation has become increasingly negative and remains very weak,” said Myria Kyriacou, foreign exchange strategist at Bank of America Merrill Lynch. “We believe the SNB will remain on hold for now but will stay vigilant and react if needed. Going further into negative rate territory cannot be ruled out.”
Ultimately, it may well be the European Central Bank that decides the fate of monetary policy in these neighbouring small open economies. Policy makers in Frankfurt have ruled out cutting the deposit rate below the current rate of -0.2 per cent, and with growth picking up in the first three months of this year, analysts think the ECB does not need to do more at present.
“At this stage, the ECB has reasons to be satisfied with its current stance,” said Gilles Moec at Bank of America Merrill Lynch.
Central bank governors as well as depositors in Sweden, Denmark and Switzerland will be hoping Mr Moec is correct and the ECB does not have to move further. Only that would ensure the race below zero in Europe is truly over.