What Is a Zero-Bound Interest Rate?
A central bank's weapons for stimulating the economy may become ineffective if short-term interest rates are "zero-bound," or hit zero. At least, that is the conventional wisdom, but the assumption has been tested in the recent past and found faulty.
In three recent cases, a central bank's action in pushing interest rates below zero seemed to have had modest success, or at least not worsened the situation. In all three cases, the action was a response to a financial crisis.
- Conventional wisdom says that interest rates are "zero-bound." That is, forcing rates below zero will not stimulate economic activity.
- That's logical: Why would anyone pay to loan money?
- In fact, rates were allowed to drift below zero in three recent crises.
- The policy may have worked, perhaps because investors sought safety.
Understanding the Zero-Bound Interest Rate
In general, short-term interest rates are loans for less than one year. Bank certificates of deposit and Treasury bills fall into this category.
For consumers and investors, these are the ultimate safe-haven investments. They pay a minimal amount of interest but there's virtually no risk of the loss of principal.
The central bank, such as the Federal Reserve in the U.S., revises lending rates periodically. It may push lending rates lower in order to stimulate economic activity or hike them higher to slow an overheated economy.
It also sets the overnight lending rate. That's the interest rate that banks (and the Fed) charge each other for borrowing and loaning money amongst themselves for very short terms (literally "overnight.")
But these adjustments by the Federal Reserve are incremental and the powers of the Fed are limited.
When Rates Reach Zero
So, what happens when short-term rates go to zero? Conventional wisdom says they can go no lower. Zero is the boundary beyond which monetary policy won't work.
After all, below zero rates mean negative interest. The borrower is asking for a loan and demanding to be paid for the privilege of taking the money. Or, a bank is accepting your cash and demanding to be paid for the privilege.
Until recently it was assumed that central banks, in setting overnight lending rates, did not have the ability to push the nominal interest rate beyond 0% and into negative territory.
And yet it happened, in three cases.
March 2020: The Federal Reserve Lowered the Fed Funds Rate to 0%-0.25% in Response to COVID-19
Yields on both the 1-month and 3-month U.S. Treasury bills dipped below zero on March 25, 2020.
March 2020: A Flight to Safety
In March of 2020, the U.S. Federal Reserve lowered the federal funds rate to a range of 0%-0.25% in reaction to the economic slowdown caused by the start of the COVID-19 pandemic.
Yields on both one-month and three-month Treasury bills dipped below zero on March 25, 2020, a week and a half after the Federal Reserve cut its benchmark rate. Amid the turmoil, investors flocked to the safety of fixed-income investments, even at a slight loss.
It was the first time that had happened in 4½ years when a brief dip below zero had occurred.
2008-2009: The Financial Crisis
The belief in this constraint was severely tested during the period following the financial crisis of 2007-2008.
The recovery was sluggish, and central banks including the U.S. Federal Reserve and the European Central Bank began quantitative easing programs which brought interest rates to record low levels.
The ECB introduced a negative rate policy (effectively a charge for deposits) on overnight lending in 2014.
The 1990s: Stagflation in Japan
Japan’s interest rate policy tested convention for decades. For much of the 1990s, the interest rate set by the Japanese central bank, the Bank of Japan, hovered near the zero bound as the country struggled to recover from an economic crash and reduce the threat of deflation.
BOJ moved to negative interest rates in 2016, by charging depositing banks a fee to store their overnight funds. Japan’s experience has been instructive for other developed markets.
In extreme conditions, it seems that central banks can pursue non-conventional means of stimulating the economy.
A study by the New York Fed found that, as interest rates hovered near the zero bound, it was important for the central bank to manage investor expectations. That might mean assuring investors that interest rates would remain low for the foreseeable future and that the bank would continue various aggressive measures such as quantitative easing and purchases of bonds on the open markets. In fact, the Fed's management of expectations made “the sum... more powerful than the component parts," the study concluded."