Lars E O Svensson: Monetary policy with a zero interest rate
Speech by Mr Lars E O Svensson, Deputy Governor of the Sveriges Riksbank, at SNS -
Centre for Business and Policy Studies, Stockholm, 17 February 2009.
The original speech, which contains various links to the documents mentioned, can be found on the Sveriges
Riksbank's website.
* * *
The Riksbank conducts a policy of flexible inflation targeting, which aims to stabilise inflation
around the inflation target and also to stabilise the real economy. To achieve this, the
Riksbank sets the repo rate and publishes a forecast for the repo rate in the years ahead.
The repo rate and the expectations of future repo rates that arise from the repo rate path
affect market interest rates, which in turn affect aggregate demand and inflation. During the
financial crisis, the functioning of the financial markets has deteriorated and the transmission
mechanism from the repo rate path to inflation and the real economy has weakened. In order
to improve the functioning of the financial markets and strengthen the link between the repo
rate path, market rates, inflation and the real economy, the Riksbank has taken a number of
special measures.1
Although the discussion of monetary policy often focuses on the repo rate and the repo rate
path, it is important to realise that it is the real interest rate and the real repo rate path that
mainly affect aggregate demand, not nominal interest rates. The real interest rate is the
nominal interest rate minus expected inflation. When the Riksbank cuts the repo rate the real
repo rate also normally falls as inflation expectations are normally sluggish. In a situation with
very weak aggregate demand, a low level of resource utilisation and low inflation a low and
perhaps even a negative real interest rate is required to stimulate the real economy and thus,
as far as possible, stabilise inflation around the inflation target and resource utilisation
around a normal level. The Riksbank cannot, however, cut the repo rate more than to zero.
But even if the repo rate is set at zero, the real interest rate may be too high to have the
desired stimulation effect on the real economy. In such a situation monetary policy faces a
binding zero lower bound for the interest rate. The major question is then how monetary
policy should be conducted, to avoid a binding zero lower bound and to escape from such a
situation by using means other than lowering the interest rate.
Why is it not possible to reduce the nominal interest rate below zero? The reason is that
money in the form of banknotes and coins yields a zero interest rate. If the interest rates for
various accounts and securities such as Treasury bills and bonds were to become negative,
households, firms and authorities would prefer to retain cash in the form of banknotes
instead of lending it or depositing it. With a zero interest rate, households, firms and
authorities become indifferent about the choice of whether to hold securities such as treasury
bills and bonds or to hold cash.2 A so-called open market operation in which the central bank
increases the monetary base and thus liquidity by buying treasury bills and bonds and paying
with cash, then becomes ineffective in the sense that the interest rate is still zero and the
only thing that happens is that households, firms and authorities hold more cash and fewer
Treasury bills and bonds. A situation with a zero interest rate is therefore also called a
liquidity trap.
The issue of monetary policy when the interest rate is zero has become topical again. Since
the autumn of last year, the outlook for the global economy has deteriorated further. At the
same time as forecasts for inflation and growth have been revised downwards, policy rates
have been lowered and are now approaching zero in several countries. In December last
year, the Federal Reserve, for example, cut its policy rate to an interval between 0-0.25 per
cent, while in Japan the policy rate is 0.1 per cent and in Switzerland 0.5 per cent.
Inflation throughout the world is also falling rapidly. It is possible that the level of inflation can
become negative and that we will thus see deflation in some countries. Deflation for a short
period is not a major problem. We even had this in Sweden a few years ago. But if deflation
is prolonged, and especially if inflation expectations fall and deflation expectations arise, the
situation can become very problematic. The combination of very low policy rates, a weak real
economy and the risk of deflation has thus revived the debate about how monetary policy
can and should be conducted in the event of a zero interest rate bound.
In the 1990s, Japan experienced a long period with a zero interest rate, deflation and,
compared with previous decades, weak real economic development. The experience gained
in Japan has stimulated extensive discussion and a great deal of research at universities and
central banks on monetary policy in connection with a zero interest rate bound. At Princeton
University, Ben Bernanke, Paul Krugman and I conducted research on this subject.3 The
Japanese experience and the research conducted on monetary policy with a zero interest
rate are now topical again.
For Sweden, a scenario with deflation and a zero interest rate is as yet not particularly likely.
However, at the Riksbank we must of course be prepared for all eventualities and consider
what measures would be possible and appropriate in such a situation. We must also think
about how we can minimise the risk of ending up in such a situation. Many observers
criticised the Japanese central bank for having reacted far too slowly and for being too
cautious about testing various methods to escape from their liquidity trap. I believe that we at
the Riksbank should be prepared with analyses and measures at an early stage. Today I will
therefore address the problem that a situation with a zero interest rate represents and the
possible alternative solutions. I will, among other things, discuss a price level target and a
method that in my research I have called the "Foolproof Way" of escaping from a liquidity
trap. Finally, I summarise how effective the alternatives may be and how they can be
selected depending on how serious the situation with a zero lower bound for the interest rate
is deemed to be.
In a situation with a zero lower bound for the interest rate, fiscal policy acquires a very
important role. How effectively an expansionary fiscal policy can stimulate the real economy
is, however, dependent on a number of factors, for example the degree of Ricardian
equivalence - that is the extent to which a reduction in public saving gives rise to increased
private saving. The initial size of the national debt, the structure of public expenditure and the
distribution between expenditure increases and tax reductions in the national budget may
also be decisive for the impact of fiscal policy on the real economy. Here, however, I only
discuss monetary policy alternatives in the event of a zero interest rate.
The problem: real interest rate too high
I have already said that, in the case of a binding zero lower bound for the interest rate, the
real interest rate is too high compared to the level appropriate to stabilise inflation around the
inflation target and at the same time stabilise the real economy. To be precise, it is the real
market rate, that is the market rate met by households and firms minus expected inflation,
that is too high. The market rate exceeds the repo rate with a spread that is determined by
various risk and liquidity premia. This spread is now unusually large due to the financial
crisis. This means that the market rates are positive even if the repo rate is zero.
With some simplification, the real market rate can be specified as:
Real market rate = Nominal market rate - expected inflation
= Repo rate + spread - expected inflation.
Even if the repo rate is reduced to zero, the real market rate can be too high, because the
spread is large and/or because the expected inflation is low.4
The real market interest rate can thus be lowered, if the spread can be reduced. The
measures implemented by the central banks and other authorities in various countries to
improve the functioning of the financial markets, what Ben Bernanke calls "credit easing",5
can reduce the spread and thus contribute to a lower market rate. However, even if the
various spreads are still larger than normal, it is, quantitatively probably only a rather
moderate reduction of the real market rate that is possible in this way. The really substantial
effect on the real market rate can instead be achieved if inflation expectations can be raised.
It is particularly dangerous if, instead, expectations of deflation arise, that is expectations of
negative inflation. The real interest rate may then become far too high. A nightmare for
central banks is a downward spiral, in which a too high real interest rate slows down the
economy and leads to increasing deflation and expectations of decreasing inflation, which in
turn lead to a still higher real interest rate that slows down the real economy even more and
leads to even greater deflation.
With a zero lower bound it is therefore important for the central banks to affect and raise
inflation expectations in some way. How this should be done is the real problem with a zero
lower bound for the interest rate bound and a liquidity trap. It may even be necessary to raise
inflation expectations above the inflation target for a while in order to achieve a sufficiently
low real interest rate. This means that the central bank must get people to believe that it will
knowingly and deliberately strive to exceed the inflation target. How can a central bank that
normally strives to create low inflation expectations and meet the inflation target promise,
with any credibility, that it will exceed the inflation target in the future?6
When we discuss and evaluate various policy alternatives for monetary policy in a liquidity
trap, we should thus start from the most important criteria for assessing their effectiveness -
how effective alternatives will be in affecting inflation expectations.
The solution: affect inflation expectations
A credible inflation target
An established and credible inflation target above zero and a transparent monetary policy will
help to ensure that inflation expectations do not fall too low and to reduce the risk of
expectations of deflation arising. The Riksbank has a major advantage in this respect in that
we already have a well-established inflation target. By publishing well-founded forecasts for
inflation, the real economy and the repo rate, the central bank can affect expectations of
inflation and future repo rates. Even if the real economy becomes weak and inflation low or
even negative in the short term, the central bank can, with a good and convincing analysis,
present forecasts in which inflation returns to the inflation target and the real economy
stabilises. This means, all in all, that the central bank's forecasts and scenarios constitute
central tools in the effort to influence inflation expectations. Central banks that already have
well-established numerical inflation targets may therefore find it easier to hold up inflation
expectations and create credibility for their policy. In countries that do not have a numerical
inflation target it may be good to introduce such a target in a situation with a binding zero
lower bound for the interest rate, although it would of course have been better to already
have the inflation target established and credible before ending up in such a situation.
Inflation targets do, however, have a disadvantage . Following a period of unwelcome low
inflation below the inflation target, inflation targeting entails, as it is usually applied, that the
central bank subsequently seeks to maintain a level of inflation in line with the target. The
central bank does not thus attempt to compensate for the previously low inflation with a
period of inflation above the target. If firms and households consequently believe that
inflation will be very low in the short term and thereafter equal to the inflation target, then the
average expectations in the slightly longer term will still be low and under the target. In such
circumstances, with a zero interest rate, the real interest rate may still be too high even if the
inflation target is credible in the longer term. One way to avoid this disadvantage is instead to
have a so-called price level target, or what may also be referred to as "average inflation
targeting".
A credible price level target
A price level target in the form of a path for the price level, in which the rate of increase in the
price level is given by the inflation target, has several advantages compared with a standard
inflation target in a situation with a zero interest rate. Unlike an inflation target, a price level
target has a "memory" in the sense that lower inflation or deflation during a period of time
whereby prices fall below the target path will be compensated for by a correspondingly
higher inflation in a later period to attain the price level target path once again. If the price
level target is credible, the long-term inflation expectations will be stable, even if low inflation
or deflation is expected in the short term. If prices have already fallen below the price level
target, a credible price level target will lead to short-term expectations of inflation rising
above the long-term average. With an unchanged nominal rate the real interest rate will then
fall and the real economy will be stimulated. A credible price level target will thus entail an
inherent automatic stabilisation in a situation with a zero interest rate.7 A price-level target
can be seen as an average inflation target for a longer period of time, for instance five
years.8
In a case where there is a risk that inflation will be too low, or even negative, for a couple of
years it may be appropriate, in order to avoid the disadvantage with a standard inflation
target that I mentioned above, to tighten the inflation target and temporarily interpret it as a
target of 2 per cent for average inflation over the next five years, for example. This would
mean that the central bank would then compensate for low inflation during the first years with
higher inflation in the subsequent years so that the five-year average is on target. The
Australian central bank, the Reserve Bank of Australia, actually formulates its target in this
way: "[T]he appropriate target for monetary policy is to achieve an inflation rate of 2-3 per
cent on average over the cycle".9 If the central bank by means of convincing analyses and
forecasts can gain credibility for such a temporary price level target - a temporary average
inflation target - the price level target's inherent stabilisation of the real economy could then
be used.10
Observe inflation and price level expectations - the exchange rate as an indicator
As expectations of the future inflation rate and the price level are so important to the
development of the real interest rate in the event of a binding zero lower bound for the
interest rate, it becomes even more important to observe and measure these expectations.
There are several ways for a central bank to observe expectations of the future price level.
The Riksbank, for example, commissions Prospera to conduct quarterly surveys about
expectations for inflation one, two and five years ahead. Inflation expectations can also be
estimated by comparing market rates for nominal and indexed bonds. In this way, the central
bank can observe whether measures taken to influence inflation expectations are having any
effect.
When the interest rate is zero the exchange rate becomes an interesting indicator of
expectations of the future price level. According to the interest rate parity condition, the
current exchange rate is determined by the expected future exchange rate, current and
expected future interest rate differentials between domestic and foreign interest rates and
expected future currency risk premia. The future exchange rate depends on future price
level, the future real exchange rate and future foreign price level. For exchange rates and
price levels expressed in logarithms we can specify the following relation:
Current exchange rate
= Expected future (exchange rate - interest rate differential + foreign exchange risk premium)
= Expected future (price level + real exchange rate - foreign price level - interest rate differential +
foreign exchange risk premium)
With an expected future domestic interest rate that is zero or low, future interest rate
differentials and foreign exchange risk premia for a small open economy are largely
exogenous and given. At a reasonably long horizon, the expected future real exchange rate
is given by a neutral real equilibrium rate and is largely exogenous for a small economy. The
expected future foreign price level is also exogenous for a small open economy.
Consequently, under these conditions, the expected future price level is practically the only
endogenous variable that affects the current exchange rate. With this reasoning, the current
exchange rate, all other things being equal, becomes a direct indicator of the expected future
price level. By observing the exchange rate, the central bank can thus observe expectations
of the future price level. Higher inflation expectations and thereby a higher expected future
price level lead then to a depreciation of the currency today, all else being equal. A measure
that raises expectations of future inflation and the future price level should thus show up in a
depreciated currency. A strengthening of the currency may therefore be ominous and
interpreted as a sign that inflation expectations are falling.11
The exchange rate as a policy instrument - "The Foolproof Way" to escape a liquidity
trap
The direct link between the current exchange rate and the expected future price level first
leads, as mentioned, to the insight that the current exchange rate depends on the expected
future price level and can be used as an indicator of the latter. But the link also leads to the
idea that cause and effect can be reversed. Instead of the expected future price level
determining the current exchange rate, the current exchange rate can determine the
expected future price level. To be more precise, the exchange rate can be used as a policy
instrument when it is no longer possible to lower the interest rate because it is already zero.
Unlike the policy rate, the exchange rate has no upper or lower limit, as Bennett McCallum
pointed out early in the discussion of Japan's liquidity trap.12 When the real economy and
inflation can no longer be stimulated by cutting the policy rate, it is still possible to achieve
the same stimulation by using the exchange rate as a policy instrument and depreciating the
currency.
This is the background to my proposal of a "Foolproof Way" for a small open economy to
escape from a liquidity trap.13 The Foolproof Way consists of the following three parts:
1. A price level target is introduced in the form of a path as I described earlier. In the
event that unwelcome low inflation or deflation has already arisen, the price level
target can be set correspondingly higher than the current price level.
2. An exchange rate target that is consistent with the price level target is announced
and the exchange rate is pegged to this exchange rate target until the price level
target is attained. If, for example, the price level is to be raised by 10 per cent, the
exchange rate target is set so that the currency depreciates by 10 per cent.
3. When the price level target has been attained, the currency is allowed to float and
monetary policy returns to normal, either with the old inflation target or with the
continued use of a price level target if this is deemed to be advantageous in the
longer term.
It is easy for the central bank to implement part (2) and keep the exchange rate at a given
level when the currency is strong and would appreciate if it were allowed to float. Initial
doubts among the market participants and the risk of this method failing means that it would
appear to be a good deal to buy domestic currency cheaply and then sell it at a higher price
when the method fails. This would lead to a high demand for the domestic currency. The
central bank, however, could sell as much domestic currency as it likes and would only see
its foreign exchange reserves increase correspondingly. A large foreign exchange reserve
and monetary base might be considered inflationary, but higher inflation and inflation
expectations are exactly what the central bank wants in this situation.
The difficult thing, in contrast, is to maintain a fixed exchange rate when the currency is weak
and would depreciate if it was allowed to float, as was the case of the speculative attacks the
Swedish krona was subjected to during the fixed exchange rate regime in the early 1990s. In
such a situation, the central bank would have to buy the domestic currency and pay with
foreign exchange reserves, which are finite and would eventually run out. When the market
realises that there is a difference between maintaining a fixed exchange rate when the
currency is strong and when it is weak, the high demand for the domestic currency will cease
and the foreign exchange reserves will return to a more normal level.
This method is a very drastic action. It shows that the central bank really means business
and lends credibility to the price level target. It may therefore affect expectations of the future
price level much more than any other measure. The method is verifiable as it consists of
action and not just talk, and its logic is very clear. Raised inflation expectations would reduce
the real interest rate, stimulate the real economy and increase inflation, and the price level
would move upwards towards the price level target. The real economy would also be
stimulated directly by the fact that exporting and import-competing sectors would be affected
positively by the short-term real depreciation that would arise due to the short-term
sluggishness of the price level. As the price level moves up towards the price level target, the
real exchange rate will, however, return to its neutral level.
Does this method represent a competitive devaluation? The answer is that this is no more of
a competitive devaluation than any other form of monetary policy expansion. Note that if the
zero lower bound for the interest rate did not exist, the central bank could reduce the real
interest rate by reducing the nominal rate. This nominal rate reduction would lead to a
depreciation of the currency. The currency depreciation in part (2) achieves the same
currency depreciation directly instead of indirectly via a reduction of the nominal interest rate.
The method is thus no more of a competitive devaluation than a reduction of the nominal
interest rate would be, if such a reduction were possible. It is quite simply a method that
entails a certain degree of monetary policy expansion, but by using means other than the
policy rate. Every measure that managed to increase expectations of the future price level
would in fact also automatically lead to a weakening of the currency. Using the exchange
rate as a policy instrument should therefore not be seen as more controversial than using
any other method that leads to expectations of a higher future price level.
Is this method to the disadvantage of other countries? The method is to the advantage or
disadvantage of other countries depending on whether a normal monetary policy expansion,
an interest rate cut, is to the advantage or disadvantage of other countries. The effects of a
small, open economy's monetary policy on other countries is normally limited, and the net
effect depends on a number of circumstances. Monetary policy is normally conducted in
each country without regard to such effects. The impact that a currency depreciation or a
monetary expansion in a larger country has on the trade balance of other countries depends
on both income and substitution effects. The former is positive due to the greater output and
the greater demand for foreign imports, while the latter is negative due to changes in the real
exchange rate and the terms of trade. Depending on the initial position, the positive income
effect can be quite substantial. However, as the income and substitution effects normally
have different signs it can be expected that the net effect is normally fairly small. This is
supported by simulation studies.14
Today, however, we have a situation in which the two largest economies in the world, the US
and Japan, both have a zero interest rate. If the authorities in these countries want to
stimulate the real economy by lowering the real interest rate further by creating higher
inflation expectations, they clearly cannot do this by depreciating their currencies against
each other at the same time. They will instead have to create such expectations by other
methods. If one of the countries manages to raise expectations of its future price level it will
be sufficient in principle, however, for the other country to keep the exchange rate constant
for its expected future price level to also rise. Roosevelt's decision to allow the dollar to
depreciate by 40 per cent against gold during the depression in the 1930's can be mentioned
as an example of a currency depreciation carried out with the express purpose of raising the
price level in the country.15
"Quantitative easing": ineffective if it is not expected to be permanent
Why not just increase the money supply in order to create expectations of a higher future
price level? As long as the interest rate is zero then households and firms, as we have
already seen, are indifferent about the choice between money and securities such as
Treasury bills or bonds. An increased supply of money will then have no effect other than
households and firms holding more money and fewer bills and bonds. However, at some
time in the future the economy will return to normal, the interest rate will be positive and
households and firms will no longer be indifferent when choosing between money and these
securities. Somewhat simplified, we can say that the money supply will once again become
approximately proportional to the price level. A larger money supply in the future will lead, all
else being equal, to a higher price level in the future. If the central bank could thus credibly
commit to a permanent and lasting increase in the money supply, the expected future price
level would rise. The problem here is, however, that there is no way for the central bank to
make a credible commitment to a larger money supply in the future. There is nothing to
prevent the central bank from reneging on such a commitment and reducing the money
supply in the future in order to reduce future inflation and keep it in line with the inflation
target.16
Experience from Japan's period of "quantitative easing" also shows that the extreme
expansion of approximately 70 per cent of the monetary base between March 2001 and
March 2006 did not noticeably affect expectations of inflation and the future price level.17 For
example, the yen did not depreciate as it should otherwise have done. Firms and households
clearly believed that the expansion of the monetary base was temporary and not permanent,
which subsequently proved to be true. The monetary base fell back to normal levels when
the interest rate was later raised to above zero.
Other measures
A number of other measures for addressing a situation with a zero interest rate have been
proposed. Even if short-term interest rates are zero or close to zero, bond rates at longer
maturities may still be positive. If the central bank therefore buys long-term bonds it may
perhaps be able to squeeze down the long-term interest rates somewhat, which should
stimulate the real economy. The central bank can also promise to keep the policy rate at zero
for a prolonged period in order to create expectations of lower future interest rates and a
more expansionary monetary policy in the future. This should also stimulate the real
15
Bernanke, Ben (2002), "Deflation: Making Sure 'It' Doesn't Happen Here", speech 21 November at the
National Economists Club, Washington, D.C., www.federalreserve.gov.
16
As Paul Krugman put it in his insightful Brookings essay - how will the central bank "credibly promise to be
irresponsible". Krugman, Paul R. (1998). "It's Baaack: Japan's Slump and the Return of the Liquidity Trap".
Brookings Papers on Economic Activity 49, 137-206.
17
Quantitative easing and credit easing are not the same thing. The first method entails deliberately increasing
the monetary base and having a quantitative target for this. The monetary base can then be seen as
supplydetermined by the central bank. The second method consists of providing new loan opportunities for the banks
in order to improve the functioning of the financial markets and reduce spreads. This method also results in an
increase in the monetary base, but this can be seen as demand-determined by the banks. See Bernanke, Ben
(2009), "The crisis and the policy response", speech at the Stamp Lecture, London School of Economics, 13
January, www.federalreserve.gov, for further discussion. (18) For a more detailed derivation and detailed
discussion, see Svensson, Lars E.O., (2006), "Monetary Policy and Japan's Liquidity Trap", working paper,
www.princeton.edu/svensson.
BIS Review 19/2009
economy. Personally, I believe that the stimulation that the central bank can achieve in this
way is very moderate, perhaps a few tens of basis points on the real interest rate in the best
case. By influencing inflation expectations more directly, the real interest rate can be reduced
by several percentage points.
Monetary policy alternatives with a zero interest rate bound: concluding comments
As both Japan and the United States now have a zero interest rate and several other
countries are now cutting their interest rates close to zero, it is natural that monetary policy
with a zero interest rate should be increasingly a subject for discussion and debate. The
most recent Monetary Policy Report contains an article on monetary policy with a zero
interest rate, and there is also an alternative scenario in Chapter 2 assuming weaker real
economic development and a repo rate path that is at zero during part of the forecast period.
Although it is not particularly likely that we in Sweden will be subjected to a strongly binding
zero lower bound for the interest rate, it is wise to be prepared for this eventuality and to
have carefully considered the monetary policy alternatives that would then be available, and
which of these would be appropriate, depending on how serious the zero lower bound was.
A zero lower bound on the interest rate means that the real interest rate is still too high to
sufficiently stimulate the real economy, despite the policy rate being cut to zero. It is the real
market rate that is important in the real economy, and this corresponds to the policy rate plus
a spread arising due to various risk and liquidity premia, minus expected inflation. Although
the policy rate is zero, nominal market rates are positive as a result of the spread. The
various measures taken by central banks and other public authorities during the financial
crisis to ensure that the financial markets function more efficiently and that the spreads
decline thus fulfil a function that is at least as important, even if the repo rate is at zero. It is
reasonable to suppose, however, that their stimulating effect is much smaller than the effect
a central bank can achieve with measures that focus on inflation expectations.
The major danger with a zero lower bound for the interest rate is that inflation expectations
will be too low and even negative, and that the real interest rate will thus become too high. It
is thus necessary to keep watch on inflation expectations, to counteract expectations of
falling inflation, and preferably to create expectations of higher inflation. In this type of
situation it may be desirable to create expectations that actually exceed the inflation target.
The Riksbank's current regime, with a credible inflation target and the publication of
forecasts, including their motivation, for inflation, the real economy and the repo rate,
provides a very good base for maintaining confidence in monetary policy, for upholding
inflation expectations and preventing them from falling too low, or even from falling
unchecked.
If, cont