Evan Soltas
Jul 19, 2012

So Long, Zero Lower Bound?

Nationalbanken
A friend of mine who follows currency markets informed me via email that Danmarks Nationalbanken, the central bank of Denmark, has cut one of their monetary policy rates below the nominal zero lower bound.

Denmark's central bank has three rates: a 7-day lending rate, a 7-day certificate of deposit rate, and an overnight current account deposit rate. The first remains positive at 0.20 percent, and the third was left unchanged at zero. But for the first time in the central bank's history, the Danes have cut their certificates of deposit rate below zero, to negative 0.20 percent.

Listen to the Danish central bank governor Nils Bernstein:

We have always used intervention and changes in our interest rate, and that is what we have done today...The new thing is that we have moved into negative territory, but fundamentally it is the same two instruments.
A strategist at a Danish commercial bank also says in the Reuters article that he could see the interest rate becoming "even more negative" if the ECB takes further action, which will prompt the Danish central bank to take action to maintain its currency peg.

I need to make three brief notes at this point. First, their cuts came in response to cuts by the European Central Bank. Second, the monetary policy objective of the Danish central bank is to maintain a very tight currency peg with the euro. In the last five years, the Danish krone has stayed within a band of three øre, the Danish equivalent of a cent, which represents approximately 0.4 percent of its value against the euro. That is far tighter than the 2.25 percent band that it is required to maintain under the European Exchange Rate Mechanism (ERM) II Central Bank Agreement. Second, Sweden's central bank cut what appears to be an identical 7-day deposit rate below the nominal zero lower bound three years ago in July 2009 -- see here for more on that. This is a more significant move than what happened in Sweden, however, because while in Sweden overnight deposits dwarfed the 7-day deposits, it's the other way around in Denmark, which is more worried about the capital-flow risks to exchange rate stability posed by large quantities of loose overnight deposits.

So what happened to the "nominal zero lower bound"? Why isn't it binding the Danish central bank? Because the Danes have multiple monetary policy rate instruments, they are able to set one negative without severe risk to the financial system.

In fact, it's worth saying that there is no such thing as a nominal zero lower bound. Interest rates can go negative, although conversion into cash may limit the depths to which it can go. Fundamentally, there is a zero lower bound on short-term nominal interest rates because central banks say there is. The Fed, for one, is worried about consequences to the financial system -- according to a post on the NY Fed's "Liberty Street" blog, these include money market funds breaking the buck, technical issues with Treasury auctions, and disruptions to the federal funds market.

A close, but not exact, equivalent action the Fed could take would be to take the 0.25 percent rate paid on excess reserves and make that negative or zero. Alternatively, it could set a cap on excess overnight reserves and require the rest to go into an expanded version of its Term Deposit Facility, which currently issues $3 billion in 28-day certificates of deposit every quarter. With this demand pressure transferred to the TDF, rates could go negative -- they are currently constrained by IOR.

Perhaps it is time for the Fed to learn something from Danmarks Nationalbanken. Or as Queen Gertrude said in Shakespeare's Hamlet in Act I, Scene 2: "[L]et thine eye look like a friend on Denmark."