Moneybestpal Team

The term "zero-bound" describes a scenario in which a central bank has cut its short-term interest rates to zero or close to zero in an effort to boost the economy. In order to stimulate the economy when interest rates are at or near zero, the central bank must turn to additional, frequently unorthodox, tools of monetary policy.

How Does the Zero-Bound Work?

One of the primary tools that central banks use to affect the amount of economic activity, inflation, and exchange rates is the interest rate. In order to boost spending and investment, central banks must cut interest rates so that borrowing is more affordable and saving is less desirable. In order to deter borrowing and investment, central banks must raise interest rates, which incentivize saving and increase the cost of borrowing.

There is a cap on how low interest rates can fall, though. Since people would rather store cash than lend or deposit money at a negative yield, interest rates are theoretically unable to go below zero. The zero lower bound (ZLB) or zero-bound is the name of this limit.

The economy is in a liquidity trap when a central bank reaches the zero-bound, making further interest rate reductions ineffective. When people have low expectations for their future income and inflation, such as during a severe recession or deflation, this can occur. Regardless matter how low interest rates are, individuals would rather conserve money than spend it in this situation.

What Are the Alternatives to the Zero-Bound?

A central bank must employ additional monetary stimulus measures to stimulate the economy when it is at the zero-bound. Some of these methods are:
  • Quantitative easing (QE): Here, a central bank purchases a sizable quantity of government bonds or other assets from the market in an effort to boost the money supply and bring down long-term interest rates. By lowering the national currency and raising the competitiveness of exports, this may also have an impact on the exchange rate.
  • Negative interest rates: In this case, a central bank essentially charges banks for keeping excess reserves by setting its policy rate below zero. As a result, people may be less likely to keep cash on hand and banks may lend out more money. Negative interest rates, however, can potentially have unfavorable side effects, like harming bank profitability and monetary stability.
  • Forward guidance: This is when a central bank announces its monetary policy goals for the future in order to affect market participants' expectations and actions. To encourage additional spending and investment, a central bank can, for instance, promise to maintain low interest rates for an extended period of time, even after the economy has recovered.

What Are Some Examples of the Zero-Bound?

The zero-bound is an actual situation. In recent years, the zero-bound dilemma has or is being faced by a number of significant central banks. Some examples are:
  • The Bank of Japan (BOJ): During the 1990s, the BOJ has struggled with deflation and slow growth. It launched numerous rounds of QE and negative interest rates after lowering its policy rate to zero for the first time in 1999. Yet, it has not been very effective in boosting inflation or the economy.
  • The Federal Reserve (Fed): In response to the 2008–2009 global financial crisis, the Fed reduced its policy rate almost to zero and started QE operations. Prior to 2015, it held its rate at zero, but as the economy recovered, it began to gradually raise it. The COVID-19 epidemic, however, forced the Fed to reduce its rate back to close to zero and restart QE in 2020.
  • The European Central Bank (ECB): Following the 2010–2012 eurozone debt crisis, the ECB also encountered the zero-bound issue. It started QE initiatives and lowered its policy rate to almost zero. In 2014, it also implemented negative interest rates for some deposits. The eurozone's economy and inflation have not, however, been sufficiently boosted by its stimulus measures.

Why Does the Zero-Bound Matter?

The zero-bound is important because it restricts how well monetary policy can boost the economy. Central banks are forced to use unusual and unreliable measures of stimulus when interest rates are at or close to zero, which limits their room for maneuver. The objectives of price stability and full employment may be more difficult for central banks to attain as a result.

The zero-bound also matters because it reflects the underlying structural problems of the economy, such as low productivity growth, an aging population, high debt levels, and weak demand. Fiscal policy support, as well as structural reforms, are also necessary to address these issues in addition to monetary policy remedies.