LESSONS FROM THE SWEDISH EXPERIENCE WITH NEGATIVE CENTRAL BANK RATES.

• Author: Andersson, Fredrik N.G.

Interest rates declined in the wake of the 2007-2009 global financial crisis. They remained low for most of the 2010s, only rising modestly toward the end of the decade. In some European countries, interest rates even became negative. While limited to a few countries initially, the likelihood of more central banks following suit is growing in the wake of the COVID-19 pandemic. Not least, the Federal Reserve System is under pressure to adopt a negative federal funds rate (Bemanke 2020; Lilley and Rogofl 2020).

The push for negative rates invites the question: What are their consequences? We examine this question empirically by analyzing the case of Sweden, one of the first countries to experiment with a negative policy rate, and the first country to complete the experiment. (1) We then discuss the implications of our results for larger economies.

The Swedish central bank, the Riksbank, first entered negative rate territory when its deposit rate for commercial banks became negative in 2009. The Riksbank became a pioneer with this one small step. However, its main policy rate, the repurchase (repo) rate, remained positive. This situation lasted for only a brief period. In 2010, the Riksbank moved away from the negative deposit rate due to a rapidly recovering economy.

The second move came in February 2015, when the Riksbank announced a repo rate of -0.10 percent. This rate was further reduced to -0.50 percent in 2016, a level maintained until January 2019, when the rate was raised to -0.25 percent. A further increase of 25 basis points followed in December that year, terminating the subzero regime after five years.

The move to a negative interest rate was an unusual step not only because the Riksbank became the first inflation-targeting central bank to break the zero lower bound, but also because the Riksbank broke its previous behavior of shadowing the European Central Rank (ECB). Figure 1 illustrates the policy rates in Sweden, the euro area, and the United States in the period between the introduction of the euro in 1999 to 2019. The Riksbank normally shadows the ECB's policy rate. Here the 2015-2019 period stands out with the Riksbank being more expansionary compared to the two major central banks judging from the main policy rates. (2)

It is too early to make a full assessment of the long-run effects of the negative rates. However, we can already observe some of the short-run consequences. Thus, we focus on how negative rates affected the Swedish economy from 2015 to 2019. We discuss why the Riksbank took the drastic step of adopting negative rates, consider the short-run effects of this policy shift, and the lessons this episode offers for other countries.

Background of the Riksbank's Negative Policy Rate

It is important to understand the background of the Riksbank's experiment with negative policy rates. They were introduced not during a time of crisis, as in many other countries, but during a time of relative prosperity with high growth and record employment levels. They were the outcome of a long drift in the Riksbank's approach to monetary policy. Over time, the Riksbank became increasingly dependent on a New Keynesian dynamic stochastic general equilibrium (DSGE) model, called Ramses. This model came to dominate the Riksbank's thinking about the Swedish economy. As inflation fell below the official inflation target of 2 percent, despite a relatively strong economy, the model's diagnosis was simple: high policy rates caused low inflation. Alternative explanations were discussed but largely disregarded in practice. The use of this specific model was a key driver behind the move toward negative rates. A broader analysis that emphasized, for example, financial stability would likely have resulted in a different policy.

Evolution of the Swedish Monetary Framework, 1993-2019

The Riksbank announced that it was adopting an inflation target in January 1993 following the collapse of the pegged exchange rate for the krona against the ECU during the European exchange rate crisis in the fall of 1992. The target was set at 2 percent within a tolerance band of plus or minus 1 percentage point. The Riksbank copied these numbers from the Bank of Canada's framework.

The initial reaction to the target was skeptical due to Sweden's history of high inflation in the 1970s and 1980s. However, inflation fell and held steady at around 2 percent from the late 1990s until the early 2010s (Figure 2). From 1993 until 2019, inflation averaged 1.7 percent, which was well within the Riksbank's original tolerance band of 1 to 3 percent (3) (Andersson and Jonung 2017). As a comparison, the average inflation rate in the euro area was 1.8 percent during the same period, and average inflation in the United States was 1.7 percent. Not only are the averages similar, but as is evident from Figure 2, the comovements among the inflation series are high, suggesting that a large share of the variation in inflation was caused by global rather than national factors. (4)

The early years of the inflation target was a period of experiment for the Riksbank, as it had no recent experience of implementing inflation targeting. It had to develop its operational and communication strategies from scratch (Andersson and Jonung 2018). The framework that emerged toward the end of the 1990s was quite simple: the goal was to keep inflation close to 2 percent, within the band of +/- 1 percentage point. The monetary policy strategy was forward-looking and described by the Riksbank as follows: "The basic rule for monetary policy is simple: if forecast inflation one to two years ahead is above/below 2 percent, the repo rate shall normally be raised/lowered in order to fulfil the inflation target. However, the rule is not applied mechanically and minor deviations from the target may be weighed against other factors" (Riksbank 2000:63).

In the early 2000s, the Riksbank became more reliant on formal economic modelling. Eventually in 2007, the Riksbank adopted a new operational strategy and a new communication strategy. A central component of the new strategy was forward guidance, in which the Riksbank began to publish forecasts of its own policy rate two to three years into the future (Andersson and Jonung 2019). The forecasts were produced using a combination of quantitative methods and qualitative discussions, with the DSGE model taking a major role in generating the quantitative forecasts and framing the qualitative discussion (Goodfriend and King 2015). (5)

The old simple rule-of-thumb approach that, if the inflation forecast was above the target, the Riksbank would increase interest rates, and vice versa, was abandoned. The new assumption imposed on the models was that "that the repo rate will develop in such a way that monetary policy can be regarded as well-balanced. In the normal case, a well-balanced monetary policy means that inflation is close to the inflation target two years ahead without there being excessive fluctuations in inflation and the real...