DEFINITION of Zero-Bound
Zero-bound is a situation that occurs when a central bank has lowered short-term interest rates to zero or nearly zero. When interest rates are this low, new methods of economic stimulus must be examined and implemented.
Zero-bound is considered a trap because it leaves a central bank with very few options if monetary policy needs to continue to be accommodative. However, as economic conditions worsened during the Great Recession, central banks got creative.
BREAKING DOWN Zero-Bound
As central banks lower interest rates, 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 engaged 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 incentives borrowing.
However, since the Great Recession, some central banks pushed the limits of zero-bound 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, the Bank of Japan and a handful of others followed suit.