Negative interest rate policy implications on exchange rates for five European countries

To stabilize inflation expectations and reduce the risk of deflation, monetary officials in Sweden, Switzerland and Denmark adopted a negative short-term interest rate policy. The European Central Bank adopted a similar policy in June 2014. A justification for a negative short-term interest rate policy was to discourage banks from holding reserves and encourage banks to make loans to businesses and consumers. The expectation being that borrowing by businesses and consumers would increase, strengthening business investment and consumer demand. Preliminary European gross domestic product (GDP) data reveal positive but modest growth since implementing negative interest rate policies but only a weak link between the negative interest rate policy and economic growth. Other potential consequences of a negative short-term interest rate policy are the impacts on exchange rate volatility and adjustment duration – persistence of real shocks - toward long-run exchange rate equilibrium.

This paper examines the impacts of negative interest rate policy on exchange rate volatility and adjustment duration for five European countries - Germany, France, Denmark, Sweden, and Switzerland. Germany and France are euro countries. Denmark and Sweden maintain the European Exchange Rate Mechanism (ERM II) with the euro countries. Switzerland maintains a floating exchange rate regime with periodic intervention to maintain exchange rate policy caps. Using data from the Europa database provided by the European Commission, this paper examines the impacts central bank interest rate policies have on exchange rate volatility and persistence of real shocks from January 2000 through December 2017 using a generalized autoregressive conditional heteroskedasticity (GARCH) model. The GARCH model allows for different responses for good and bad news as well as negative and positive interest rate policies. The paper examines the effective exchange rates and bilateral exchange rates with the eurozone and the U.S. dollar. All data will be adjusted for inflation.

Preliminary results are not available at this time; a draft copy of the paper will be available for review by the beginning of February 2018. I expect that the adjustment period for Switzerland, Denmark, and Sweden will be relatively shorter than for France and Germany. I anticipate that the negative interest rate policy will have greater impact on France because their government policies lead to relatively lower economic freedom.