Zero-Bound

What Is Zero-Bound?

Zero-bound is an expansionary monetary policy tool where a central bank lowers short-term interest rates to zero, if needed, to stimulate the economy. A central bank that is forced to enact this policy must also pursue other, often unconventional, methods of stimulus to resuscitate the economy.

KEY TAKEAWAYS

  • Zero-bound is an expansionary monetary policy tool where a central bank lowers short-term interest rates to zero, if needed, to stimulate the economy.

  • Central banks will manipulate interest rates to either stimulate a stagnating economy or dampen an overheating one.

  • The Great Recession forced some international central banks to push the limits of zero-bound below the numerical level and implement negative rates to spur growth and spending.1

Understanding Zero-Bound

Zero-bound refers to the lowest level that interest rates can fall to, and logic dictates that zero would be that level. The main arrow in a central bank's monetary policy quiver is interest rates. The bank will manipulate interest rates to either stimulate a stagnating economy or dampen an overheating one. Clearly, there are limits, especially at the lower end of the range.

The zero-bound is the lower limit that rates can be cut to, but no further. When this level is reached, and the economy is still underperforming, then the central bank can no longer provide stimulus via interest rates. Economists use the term liquidity trap to describe this scenario.

When faced with a liquidity trap, alternative procedures for monetary stimulus often become necessary. Conventional wisdom was that interest rates could not move into negative territory, meaning once interest rates reach zero or are close to zero, for example, 0.01%, monetary policy has to be altered to continue to stabilize or stimulate the economy.

The most familiar alternative monetary policy tool is perhaps quantitative easing (QE). This is where a central bank engages in a large-scale asset-buying program, often involving treasuries and other government bonds. Not only will this keep short-term rates low, but it will push down longer-term rates, which further incentivizes borrowing.