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Bankers Watch as Sweden Goes Negative

For a world first, the announcement came with remarkably little fanfare.

But last month, the Swedish Riksbank entered uncharted territory when it became the world’s first central bank to introduce negative interest rates on bank deposits.

But, as they contemplate their exit strategies after the extraordinary measures of the past two years, central bankers will be monitoring the Swedish experiment closely.

Mervyn King, the Bank of England governor, has hinted he may follow the Swedish example as the danger of a so-called liquidity trap, where cash remains stuck in the banking system and does not filter out to the wider economy, is an increasing concern for the UK.

Hoarding is exactly what happened in Japan earlier this decade when the Bank of Japan implemented quantitative easing between 2001 and 2006.

Japanese banks refused to lend, in spite of central bank stimulus, because of fears over the dire state of the economy.

If this continues to happen in other economies, central bankers may be left with little choice but to follow the Swedish example. John Wraith, head of sterling rates product development at RBC Capital Markets, says: “The success of the UK’s quantitative easing experiment hinges a lot on whether the banks will use the extra money they are getting for lending to individuals and businesses.

“If there is no sign of this over the next few months, then the Bank of England might consider a negative interest rate. In essence, it is a fine on banks that refuse to lend.”

In the UK, for example, nearly £140bn has been injected into the economy through central bank purchases of government bonds and corporate assets, mainly from the commercial banks.

Our interactive feature explains how quantitative easing works and how this policy may stimulate the economy.

However, since the QE project was launched on March 5, a lot of this money, which in theory should be used by the commercial banks for lending to businesses and individuals, has ended up at the Bank of England in reserves.

Commercial bank deposits have risen from £31bn in early March to £152bn at the end of July – the latest figure.

This in itself is not a problem as the banks could be using this big increase in their reserves to step up their lending to the private sector. The more the banks have in reserves, the more they are allowed to lend.

However, there is no sign yet that they are using their much bigger reserves to lend on. The latest money supply figures for lending are still fairly anaemic.

It is why Mr King did not rule the possibility of negative interest rates when asked about the Riksbank model this month following the unveiling of the quarterly inflation report. “It’s an idea we will certainly be looking at, whether the effectiveness of our asset purchases could be increased by reducing the rate at which we remunerate reserves,” he said. His comments are one reason why yields on short-dated UK government bonds have fallen to record lows and why sterling has been under pressure in the currency markets.

Initially, Mr King gave QE six months before it would start taking effect. That time limit is up next week. If there are no signs in the money supply numbers, particularly in the key M4 lending excluding financial institutions, then the policy may start to look a distinct possibility.

In Europe, the European Central Bank is considered less likely to introduce negative interest rates.

This is because it has maintained higher official rates than other banks and used money market operations to act as a stimulant instead. For example, it offered commercial banks unlimited funds for one year at the end of June.

But it does have the same problem as the Bank of England in assessing the success of its policy. Like the UK, commercial bank deposits at the ECB have shot up in the past few months.

Banks pay price for policy

Sweden’s decision to introduce negative interest rates on deposits at the Riksbank means that commercial banks have to pay for the privilege of saving their money at the central bank, writes David Oakley.

The new rate of minus 0.25 per cent forces banks to pay 0.25 per cent to the Riksbank. Normally, banks would be paid interest on these deposits.

It is thought to be the first time that negative rates have been introduced. Central banks usually shy away from such a drastic policy because it is in effect a tax or fine on the commercial banks and could hurt their balance sheets.

However, the Riksbank hopes that by charging banks for saving their money, rather than paying them, it will encourage them to increase their lending to individuals and businesses, boosting the economy. It also hopes that it might encourage them to divert the money into other assets, such as government bonds or even highly rated corporate bonds. This would bring down bond yields and act as an stimulant.

In the UK, there have been signs that banks are switching cash into short- dated government bonds following hints from Mervyn King, Bank of England governor, that the policy could be introduced there.

At this stage, the US also seems unlikely to introduce the policy as there has been little debate on the matter and no hints from policymakers about it being an option.

At the Riksbank, which now has a deposit rate of minus 0.25 per cent, the most vocal advocate of the policy is deputy governor Lars Svensson, a world-renowned expert on monetary policy theory and a close associate of Ben Bernanke, chairman of the US Federal Reserve, since they worked together at Princeton University.

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