What Happened

Global central banks have had little success using quantitative easing, or the large-scale purchase of domestic financial assets, and low or negative interest rates to raise inflation and pull economies out of slow-growth traps. Sweden is bucking the global trend in a limited way as its central bank, the Riksbank, is expected to raise its main policy rate from −0.25 percent to zero on Dec. 19. The move would end Sweden's five-year experiment with negative interest rates, although the zero rate will remain for at least two years. Concerns in Sweden over increased financial vulnerabilities and asset price bubbles, especially in housing, outweigh worries about the impact of even small monetary tightening in the face of economic slack. Indeed, there is no data-driven reason for Sweden to raise interest rates now with growth lower than expected and inflation below target.

Why It Matters

Major central banks will watch the Swedish example closely for clues about how to "unwind" low and negative interest rates. They are unsure how to "normalize" monetary policy without doing damage to economies experiencing lower than average growth.

Negative interest rates certainly seem counterintuitive. Until the global financial crisis of 2008-2009 central bankers thought rates couldn't go lower than zero — what was called the "zero lower bound." To avert deflation, quantitative easing and experimentation with negative rates were the proposed answer. Negative interest rates, in particular, were intended to encourage banks to lend more money to businesses and consumers and encourage more spending to boost the economy. Results are mixed, at best, and there is controversy over the impact.

Central bank policy rates are benchmarks for other interest rates ranging from government bonds to corporate debt. An estimated $17 trillion of negative-yielding bonds are outstanding globally, including on many European sovereign debts, meaning investors must pay more than they will get back on those instruments if held to maturity. Regardless of returns, however, banks and pension funds are required to hold such super-safe assets, while other investors are betting that prices will appreciate further and they won't take losses. Even though the U.S. Federal Reserve still has a positive policy rate, U.S. markets are not immune from negative returns, with U.S. Treasury debt briefly in that territory in 2014 as demand outstripped supply and prices increased. As attractive as that might seem for the U.S. government, lenders and investors would not accept such an upside-down relation for long, undermining U.S. capital markets.

Sweden's action is the first explicit recognition by a Western central bank that costs may outweigh benefits the longer that policies meant to be temporary remain in place. Moreover, there is increased debate about whether negative interest rates and quantitative easing have helped at all and whether those policies are becoming permanent.

Negative rates penalize savers and reward borrowers, inverting normal financial relations. They spur lenders and investors to search for yield among normally uncreditworthy borrowers. Negative rates are also equivalent to a tax on banks, squeezing profits and possibly raising lending rates and lowering demand for bank loans. Other financial distortions include undermining the ability of businesses to calculate discounted returns in deciding whether to invest in new facilities and equipment, undermining long-term economic growth.

What's Next?

None of the largest central banks — the Fed, the European Central Bank (ECB), the Bank of Japan or the Bank of England — will raise interest rates under current circumstances and are on prolonged policy "holds." Nevertheless, exiting 10-plus years of accommodative monetary policies is increasingly necessary as recession fears linger and there is little or no room to cut rates further or add monetary stimulus.

Quantitative easing in Europe is also limited, with the stock of safe assets for ECB purchases nearly exhausted. The ECB already holds about one-third of the sovereign bonds of Germany and the Netherlands, and the amount of German sovereign debt is falling, forcing the ECB to look at buying riskier assets such as sub-investment grade corporate debt.

In addition, large and increasing public debts constrain fiscal policy as an alternative or complement to monetary policy. A limited number of countries have fiscal "policy space" for increased spending, including Germany, which seems unwilling to undertake massive stimulus for the benefit of others. Euro area fiscal rules preclude others from incurring massive new debt, which constrains fiscal stimulus. Meanwhile, the United States is near or at full employment with a budget deficit of $1 trillion for 2019.

Monetary policy is like pushing on a string. The transmission process works through the supply of bank lending, but there is no way to force banks to lend or borrowers to borrow. How central banks escape this dilemma without choking off already low economic growth requires new creative thinking that apparently is in short supply, leaving the global economy facing a potential policy vacuum in the next crisis.