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. 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.
The 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 wasthat interest rates could notmove intonegative territory, meaningonce 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 perhaps quantitative easing (QE). This is where a central bank engages in a large-scale asset-buying program, often involving 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.
Negative Rates
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 recoveryremained slow, central banks began entering the uncharted territory of negative rates.
Sweden was the first country to enterthisterritory, 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 othersfollowed suit at one time or another.
There are instances where negative rates have been implemented during normal times. Switzerland is one such example; through much of the 2010s, its target interest rate was-0.75%, which was raised to -0.50% in 2021. Japan similarly had adopted a negative interest rate policy (NIRP), with a target rate of -0.1%.
Example of Zero-Bound and Negative Interest Rates in Switzerland
The Swiss National Bank (SNB) maintains a negative interest-rate policy. 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.
In the Swiss example, negative interest rates are only applied to Swiss franc bank balances over a certain threshold.
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 SNB 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 this situation, the SNB will eventually adopt a zero-bound strategy for moving back to 0% and above. However, that won't happen until the central bank feels it can raise rates without causing too significant of a rise in the currency.
