What is a 'Zero-Bound Interest Rate'

Zero-bound interest rate is a reference to the lower limit of 0% for short-term interest rates beyond which monetary policy is not believed to be effective in stimulating economic growth.

BREAKING DOWN 'Zero-Bound Interest Rate'

Zero bound interest rate assumptions have been upended in recent years. In monetary policy, reference to a zero bound on interest rates means that the central bank can no longer reduce the interest rate to encourage economic growth. As the interest rate approached the zero bound, the effectiveness of monetary policy as a tool was assumed to be reduced. The existence of this zero bound acted as a constraint on central bankers trying to stimulate the economy.

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 this limit of 0%, into negative territory.

The belief in this constraint as a handicap to monetary policy was severely tested during the period following the financial crisis of 2007-2008. Sluggish recovery followed it as central banks, including the U.S. Federal Reserve (beginning in 2008) and the European Central Bank, began quantitative easing programs (beginning in 2012), which brought interest rates to record low levels. The ECB introduced a negative rate policy (a charge for deposits) on overnight lending in 2014.

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 part of its zero interest rate policy (ZIRP) as the country attempted to recover from an economic crash and reduce the threat of deflation. Japan’s experience has been instructive for other developed markets. BOJ moved to negative interest rates in 2016, by charging depositing banks a fee to store their overnight funds.

In addition to the ability to impose negative interest rates in extreme conditions, central banks can choose to pursue other non-conventional means of stimulating the economy to achieve the same ends. A New York Fed study finds that as interest rates hovered near the zero bound, market participants’ expectations for future rates as well as other central bank actions such as quantitative easing, purchases of bonds on the open markets and other financial market factors interacted, making “the sum is more powerful than the component parts.”

While the goal of pushing past that zero bound and pursuing negative interest rate policies is to stimulate lending and boost a weak economy, negative interest rates are harmful to banking sector profitability and potentially to consumer confidence.

RELATED TERMS
  1. Zero-Bound

    Zero-bound is when interest rates reach such low levels that ...
  2. Negative Interest Rate Policy (NIRP)

    A negative interest rate policy (NIRP) is a tool whereby nominal ...
  3. Negative Interest Rate

    Negative interest rates refer to the case when cash deposits ...
  4. Bank Rate

    A bank rate is the interest rate at which a nation's central ...
  5. Low Interest Rate Environment

    A low interest rate environment is when the risk-free rate of ...
  6. Monetary Policy

    Monetary policy is the actions of a central bank, currency board ...
Related Articles
  1. Insights

    How the Fed Profits From Quantitative Easing

    Central Banks including the U.S. Federal Reserve are making rich profits from stimulative measures such as Quantitative Easing (QE).
  2. Personal Finance

    How Negative Interest Rates Affect Mortgages

    Negative interest rates are wrecking havoc on conventional mortgage lending in Europe.
  3. Trading

    Why Negative Interest Rates Are Not Working

    Find out why negative interest rate policies are failing because bond buyers do not want a negative yield and saturated borrowers want to pay off debts.
  4. Insights

    Hungary First Emerging Market to Adopt NIRP

    On Tuesday, the National Bank of Hungary cut its overnight deposit rate to -0.05%, becoming the sixth central bank to charge banks to deposit money with it.
  5. Investing

    Why Negative Interest Rates Are Still Not Working in Japan

    Japan's negative interest rate policy has failed to generate economic growth, but the central bank keeps trying to print up prosperity.
  6. Investing

    The Negative Rates of Europe's Central Banks

    We are currently seeing negative central bank deposit rates and government and corporate bonds with negative yields, but there are investors buying into these securities. Why?
  7. Insights

    10 Countries With Lower Interest Rates Than the US

    Learn about the 10 countries with lower interest rates than the United States and how interest rates indicate a country's economic outlook.
  8. Insights

    Fiscal Policy vs. Monetary Policy: Pros & Cons

    When it comes to influencing macroeconomic outcomes, governments have typically relied on one of two courses of action: monetary policy or fiscal policy.
  9. Personal Finance

    Bank Profitability in the Era of Low Interest Rates

    The "low-for-long" policy on interest rates presents a major challenge to bank profitability.
  10. Personal Finance

    How the Federal Reserve Affects Your Mortgage

    The Federal Reserve can impact the cost of funds for banks and consequently for mortgage borrowers when maintaining economic stability.
RELATED FAQS
  1. What are the implications of a low federal funds rate?

    Find out what a low federal funds rate means for the economy. Discover the effects of monetary policy and how it can impact ... Read Answer >>
  2. How do interest rate changes affect the profitability of the banking sector?

    Learn how interest rates affect the banking sector. When interest rates rise, the profitability of the banking sector increases. Read Answer >>
Hot Definitions
  1. Inflation

    Inflation is the rate at which prices for goods and services is rising and the worth of currency is dropping.
  2. Discount Rate

    Discount rate is the interest rate charged to commercial banks and other depository institutions for loans received from ...
  3. Economies of Scale

    Economies of scale refer to reduced costs per unit that arise from increased total output of a product. For example, a larger ...
  4. Quick Ratio

    The quick ratio measures a company’s ability to meet its short-term obligations with its most liquid assets.
  5. Leverage

    Leverage results from using borrowed capital as a source of funding when investing to expand the firm's asset base and generate ...
  6. Financial Risk

    Financial risk is the possibility that shareholders will lose money when investing in a company if its cash flow fails to ...
Trading Center