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.

Zero-Bound Interest Rates and Monetary Policy

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.

In March 2020, the Federal Reserve lowered the Fed Funds Rate to 0%-0.25% in response to the coronavirus.

Yields on both the 1-month and 3-month U.S. Treasury bills dipped below zero on March 25, 2020

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. But, 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. Yields on both the 1-month and 3-month Treasury bills dipped below zero on March 25, 2020, a week and a half after the Federal Reserve cuts its benchmark rate to near zero and as investors have flocked to the safety of fixed income amid general market turmoil. It was the first time that happened in 4½ years, when both bills briefly flashed red and yields fell to minus-0.002% each.

The belief in this constraint as a handicap to monetary policy was also 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.