A scary story: The Zero Lower Bound and exchange rate dynamics
I was in Sweden last week and again yesterday (today I am in Norway). My trips to Sweden have once again reminded me about the dangers of conducting monetary policy with interest rates at the Zero Lower Bound (ZLB). The Swedish central bank - Riksbanken - has cut is key policy rate to 1% and is like to cut it further to 0.75% before the end of the year so we are inching closer and closer to zero. Riksbanken is just one of a number of European central banks close to zero on interest rates - most notably the ECB is at 0.25%. In the Czech Republic the key policy rate stands at 0.05%. And even Poland, Hungary, Norway are moving closer and closer to the ZLB. Most of these central banks seem to be quite unprepared for what might happen at the Zero Lower Bound. In this post I will particularly focus on the exchange rate dynamics at the ZLB. A Taylor rule world Lets say we can describe monetary policy with a simple Taylor rule: r = rN+a*(p-pT)+b(ygap) In a "normal" world where everything is fine and the key policy rate (r) is well-above zero the central bank will hike or cut r in response to increasing or declining inflation (p) relative to the inflation target (pT) or in response to the output gap (ygap) increasing or decreasing. If the output gap is closed and inflation is at the inflation target then the central bank will set it's key policy rate at the "natural" interest rate rN. What happens at the ZLB? However, lets assume that we are no longer in a normal world. Lets instead assume that p is well below the inflation target and the output gap is negative. As we know this is the case in most European countries today. So if we plug these numbers into our Taylor rule above we might get r=1%. As long as r>0 we are not in trouble yet. The central bank can still conduct monetary policy with its chosen instrument - the key policy interest rate. This is how most inflation targeting central banks in the world are doing their business today. But what happens if we get a negative shock to the economy. Lets for example assume that an overheated property markets starts to cool gradually and real GDP starts to slow. In this case the central bank according to it's Taylor rule should cut its key policy rate further. Sooner or later the central bank hits the ZLB. An then suddenly the currency starts strengthening dramatically In fact imagine that the interest rate level needed to close the output gap and keep inflation at the inflation target is -2%. We can say that monetary policy is neutral when the central bank sets interest rates according to the Taylor rule, but if interest rates are higher than the what the Taylor rule stipulates then monetary policy is tight. So if the Taylor rule tells us that the key policy rate should be -2% and the actual policy rate is zero then monetary policy is of course tight. This is what many central bankers fail to understand. Monetary policy is not necessarily easy just because the interest rate is low in a historical or absolute perspective. And this is where it gets really, really dangerous because we now risk getting into a very unstable economic and financial situation - particularly if the central bank insists that monetary policy is already easy, while it is in fact tight. What happens to the exchange rate in a situation where monetary policy is tightened? It of course appreciates. So when the "stipulated" (by the Taylor rule) interest rate drops to for example -2% and the actual interest rate is at 0% then obviously the currency starts to appreciates - leading to a further tightening of monetary conditions. With monetary conditions tightening inflation drops further and growth plummets. So now we might need an interest rate of -4 or -7%. With that kind of monetary tightening you will fast get financial distress. Stock markets start to drop dramatically as inflation expectations plummets and the economy contracts. It is only a matter of time before the talk of banking troubles start to emerge. The situation becomes particularly dangerous if the central bank maintains that monetary policy is easy and also claim that the appreciation of the currency is a signal that everything is just fine, but it is of course not fine. In fact the economy is heading for a massive collapse if the central bank does not change course. This scenario is of course very similar to what played out in the US in 2008-9. A slowdown in the US property market caused a slowdown in the US economy. The Fed failed to respond by not cutting interest rates aggressive and fast enough and as a consequence we soon hit the ZLB. And what happened to the dollar? It strengthened dramatically! That of course was a very clear indication that monetary conditions were becoming very tight. Initially the Fed clearly failed to understand this - with disastrous consequences. But don't worry - there is a way out The US is of course special as the dollar is a global reserve currency. However, I am pretty sure that if a similar thing plays out in other countries in the world we will see a similar exchange rate dynamics. So if the Taylor rule tells you that the key policy rate should be for example -4% and it is stuck at zero then the the currency will start strengthening dramatically and inflation and growth expectations will plummet potentially setting off financial crisis. However, there is no reason to repeat the Fed's failure of 2008. In fact it is extremely easy to avoid such a scenario. The central bank just needs to acknowledge that it can always ease monetary policy at the ZLB. First of all it can conduct normal open market operations buying assets and printing its own currency. That is what we these days call Quantitative Easing. For small open economies there is an even simpler way out. The central bank can simply intervene directly in the currency market to weak its currency and remember the market can never beat the central bank in this game. The central bank has the full control of the printing press. So imagine we now hit the ZLB and we would need to ease monetary policy further. The central bank could simply announce that it will weaken its currency by X% per months until the output gap is close and inflation hits the inflation target. It is extremely simple. This is what Lars E.O. Svensson - the former deputy central bank governor in Sweden - has termed the foolproof way out of deflation. And even better any central bank, which is getting dangerously close to the ZLB should pre-announce that it will in fact undertake such Svenssonian monetary operations to avoid the dangerous of conducting monetary policy at the ZLB. That would mean that as the economy is moving closer to the ZLB the currency would automatically start to weaken - ahead of the central bank doing anything - and in that sense the risk of hitting the ZLB would be much reduced. Some central bankers understand this. For example Czech central bank governor Miroslav Singer who recently has put a floor under EUR/CZK, but unfortunately many other central bankers in Europe are dangerously ignorant about these issues. PS I told the story above using a relatively New Keynesian framework of a Taylor rule, but this is as much a Market Monetarist story about understanding expectations and that the interest rate level is a very bad indicator of the monetary policy stance.