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.

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. There are instances where negative rates have been implemented during normal times. Switzerland is one such example; as of mid-2019 their target interest rate is -0.75%. Japan adopted a similar policy, within a mid-2019 target rate of -0.1%.

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.

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 quantitative easing. This is where a central bank engages in a large-scale asset-buying program, often 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.

Since the Great Recession of 2008 and 2009, some central banks pushed the limits of zero-bound below the numerical level and implemented negative rates. As the global economy plummeted, central banks slashed rates to spur growth and spending. However, as the recovery remained slow, central banks began entering the uncharted territory of negative rates. 

Sweden was the first country to enter this territory, when in 2009 the Riksbank cut the repo rate to 0.25%, which pushed the deposit rate to -0.25%. Since then, the European Central Bank (ECB), the Bank of Japan (BOJ), and a handful of others followed suit at one time or another. 

Example of Zero-Bound and Negative Interest Rates in Switzerland

As of July 1, 2019, the Swiss National Bank (SNB) maintains a negative interest-rate policy, with a target rate of -0.75%. While there are other examples of negative interest rates, the Swiss example is rather unique in that the country is opting to keep rates very low (and negative) to prevent its currency from rising too significantly.

Switzerland is viewed as a safe-haven, with low political and inflation risk. Other examples of negative and zero-bound interest rate policies have often come about because of economic turmoil which requires cutting interest rates to stimulate the economy. The Swiss situation doesn't fit this scenario.

The Swiss National Bank has maintained that it must keep rates low to prevent its already relatively high currency value from going even higher. A rising currency hurts the Swiss export industry. Therefore, the SNB has taken a two-pronged approach to control the currency. The Bank has actively engaged in currency market interventions to help cap the strong Swiss franc, and also keeps interest rates low or negative to dissuade strong speculative buying of the franc.

In April 2019, SNB Chairman Thomas Jordon said that raising rates to -0.75% to 0% would cause too great of a rise in the franc and hurt the economy.

In this situation, the SNB will eventually adopt a zero-bound strategy for moving back to 0% and above. That won't happen until the central bank feels it can raise rates without causing too significant of a rise in the currency.

In the Swiss example, negative interest rates are only applied to Swiss franc bank balances over a certain threshold. The minimum threshold is at least 10 million francs (subject to change).