What Is a Zero-Bound Interest Rate?
Let me explain what a zero-bound interest rate really means. When a central bank's tools for boosting the economy hit short-term interest rates at zero, conventional thinking says they've reached their limit and become ineffective. But I've seen this assumption tested in recent years, and it doesn't always hold up.
In three notable instances, central banks pushed rates below zero with some modest success—or at least without making things worse. Each time, it was in response to a major financial crisis, showing that sometimes you have to challenge the norms to keep the economy moving.
Key Takeaways
- Conventional wisdom claims interest rates are zero-bound, meaning pushing them below zero won't stimulate the economy.
- Logically, no one would pay to lend money, but rates did go negative in three recent crises.
- This policy might have worked because investors were prioritizing safety over returns.
Understanding the Zero-Bound Interest Rate
Short-term interest rates typically cover loans under a year, like bank certificates of deposit or Treasury bills. For you as a consumer or investor, these are the go-to safe havens—they offer minimal interest but almost no risk of losing your principal.
The central bank, such as the Federal Reserve in the US, adjusts lending rates regularly. They'll lower them to spur economic activity or raise them to cool things down. They also set the overnight lending rate, which is what banks charge each other for very short-term loans—literally overnight.
These changes are usually small, and the Fed's power has its limits. That's where the zero-bound comes into play.
When Rates Reach Zero
So, what happens when short-term rates hit zero? The old school of thought says that's the end of the line—monetary policy can't push any further. Negative rates would mean borrowers get paid to take money, or banks charge you to hold your cash, which sounds absurd.
Until recently, everyone assumed central banks couldn't set nominal rates below 0% for overnight lending. But it has happened, and I've got three examples to show you.
March 2020: A Flight to Safety
In March 2020, the US Federal Reserve slashed the federal funds rate to 0%-0.25% to counter the economic hit from the COVID-19 pandemic. Just a week and a half later, yields on one-month and three-month Treasury bills went below zero on March 25.
This was amid massive market chaos, with investors rushing to fixed-income safety, even if it meant a small loss. It was the first time in over four years that rates had dipped negative like this.
2008-2009: The Financial Crisis
The 2007-2008 financial crisis really put the zero-bound theory to the test. Recovery was slow, so central banks like the Fed and the European Central Bank (ECB) rolled out quantitative easing, driving rates to historic lows.
The ECB went further in 2014, introducing negative rates by charging for overnight deposits. It was a bold move to shake things up.
The 1990s: Stagflation in Japan
Japan has been testing interest rate conventions for decades. Through much of the 1990s, the Bank of Japan's rates stayed near zero as the country fought an economic crash and deflation risks.
In 2016, they finally went negative, charging banks to park their overnight funds. Japan's long experience has given other developed markets valuable lessons on handling these scenarios.
Crisis Tactics
When things get extreme, central banks can turn to unconventional methods to stimulate the economy. A New York Fed study emphasized that near the zero bound, managing investor expectations is key.
That means promising low rates for the long haul and sticking with aggressive steps like quantitative easing and bond purchases. As the study put it, the Fed's approach made the whole strategy more effective than its individual parts.
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