Currency depreciation with a binding lower bound for the policy rate

[English translation of Ekonomistas post (in Swedish).]

When the policy rate has reached its lower bound (which is not necessarily zero, but perhaps minus 0.25 or even minus 0.50 percent), there are in addition to forward guidance about the future policy rate several so-called unconventional means to pursue more expansionary monetary policy, if needed. They include asset purchases (balance sheet policies) and exchange-rate policy. As inflation in Sweden has been around zero for several years, and unemployment has remained very high, such unconventional means may well be needed for the Riksbank to fulfill its mandate to stabilize both inflation around the inflation target and resource utilization around a long-run sustainable level.

The recent experience of the Czech National Bank may be very relevant in this context. The CNB has in the last year, in a situation with a binding lower bound for the policy rate, made an apparently successful monetary policy experiment by depreciating the Czech currency and introducing an exchange-rate floor in order to better meet its inflation target and get the economy out of its long recession.

When the policy rate has reached its lower bound, exchange-rate policy and currency interventions may be a particularly effective way in small open economies to conduct a more expansionary monetary policy. This I discussed briefly at the monetary policy meeting in February 2009 and in more detail in a speech shortly thereafter. There, I also referred to the “the foolproof way of escaping from a liquidity trap“, which I have advocated for Japan as a way to get out of its liquidity and deflationary trap. The Foolproof Way consists of three parts:

(1) A temporary price-level target above the current price level.

(2) A depreciation of the currency and an exchange-rate floor defended by unlimited foreign-exchange interventions, in order to create expectations of higher inflation and thereby lower real interest rates and through this and the currency depreciation increase aggregate demand and inflation.

(3) An exit strategy. When the price-level target is reached, the exchange-rate floor and the foreign-exchange interventions are abandoned and monetary policy switches back to inflation targeting (or to price-level targeting with a price-level target path that increases at a rate equal to the inflation target).

Incidentally, my colleague on the Riksbank Executive Board, Svante Öberg, immediately objected to my ideas, both at the meeting in february 2009 and in a speech two weeks after mine. Furthermore, the Governor Stefan Ingves gave a newspaper interview stating that the inflation target would not be abolished (in spite of me rather talking about a temporary strengthening of the inflation target). (I have so far not been able to find the interview on the web and confirm the date and newspaper.) This strong resistance instead of a constructive discussion gave a premonition of the conflicts within the Executive Board that would gradually develop.

The Swiss National Bank has since 2011 successfully used currency interventions to defend an exchange-rate floor for the Swiss franc at CHF 1.20 per euro in order to prevent the currency to become too strong. However, this has not prevented the outlook for inflation and the real economy from deteriorating (see the september 2014 monetary policy assessment of the SNB).

The Czech National Bank has gone a step further, by first depreciating the currency and then defending an exchange-rate floor at a weaker level. The CNB Governor Miroslav Singer shared experiences from this experiment at a recent conference in Vienna, which I attended. The CNB had earlier lowered the policy rate to zero, but inflation and inflation expectations remained low relative to the inflation target of 2 percent. In November 2013, the CNB depreciated the koruna by introducing an exchange rate floor at a weaker level, CZK 27 per euro, than the then prevailing exchange rate.
With reference to the table below of macroeconomic indicators, Singer argued that developments in the Czech Republic had reversed and improved since the depreciation and the introduction of the exchange-rate floor. The numbers certainly supports that conclusion.


Singer’s presentation is available here. A detailed report about this monetary policy experiments is available here (including a summary of the literature and related historical experiences).