A central bank’s strategies for stimulating the economy may appear to lose effectiveness when short-term interest rates are “zero-bound,” meaning they hit zero. While traditionally thought to be the upper limit, recent events have shown otherwise. In several instances, central banks have successfully delved into negative interest territory during financial crises, revealing that the boundaries can indeed be pushed.
Key Takeaways
- Conventional wisdom asserts that interest rates are “zero-bound.” This means forcing rates below zero is believed not to stimulate economic activity.
- This idea seems logical: Who would pay for the privilege of lending money?
- However, rates dipped below zero during three critical economic crises, revealing that the policy might be more flexible.
- Investors may accept slight losses in pursuit of safer investment options.
Understanding the Zero-Bound Interest Rate
Typically, short-term interest rates are loans with a duration of less than one year. Safe-haven investments such as bank certificates of deposit and Treasury bills fall under this category. Despite their minimal interest, these investments come with virtually no risk to the principal. Central banks, like the Federal Reserve in the U.S., frequently adjust lending rates to stimulate economic activity or control inflation. They also set the overnight lending rate, which is the rate banks charge each other for short-term loans, often overnight.
When Rates Reach Zero
So, what happens as short-term rates approach zero? Conventional wisdom suggests they can’t go any lower. A rate below zero implies negative interest, where the lender pays the borrower for taking money. It was once assumed that central banks could not set these rates below 0%, but recent cases have disproved this.
Case Studies of Zero-Bound Interest Rates
March 2020: Response to COVID-19
In March 2020, the U.S. Federal Reserve lowered the federal funds rate to 0%-0.25% due to the economic consequences of the COVID-19 pandemic. By March 25, yields on one-month and three-month Treasury bills had dipped below zero as investors rushed to safer investments, even accepting slight losses. This event marked a significant shift, happening after nearly five years since the previous near-zero dip.
2008-2009: The Financial Crisis
The period following the 2008 financial crisis severely tested the assumption of zero-bound interest rates. Recovery was slow, prompting central banks like the U.S. Federal Reserve and the European Central Bank to initiate quantitative easing, which brought interest rates to unprecedented lows. The European Central Bank even introduced a negative rate policy on overnight lending in 2014, effectively charging for deposits.
The 1990s: Stagflation in Japan
Japan’s experience in the 90s provided further insights. Throughout the decade, the Bank of Japan kept interest rates near zero as it struggled with economic stagnation and deflation. In 2016, Japan moved to negative interest rates, imposing fees on banks for overnight deposits. Japan’s experience has been a learning template for other developed markets.
Crisis Tactics: Moving Beyond Conventional Methods
Extreme economic conditions have shown that central banks can implement unconventional strategies to stimulate the economy. A New York Federal Reserve study highlighted the importance of managing investor expectations when interest rates hover near zero. They found that promising sustained low rates and continuing aggressive measures like quantitative easing made the collective impact stronger than individual policies.
Related Terms: Monetary Policy, Quantitative Easing, Federal Reserve, Treasury Bills, Negative Interest Rate.
References
- U.S. Department of the Treasury. “Daily Treasury Yield Curve Rates”.
- The Federal Reserve System. “Federal Reserve Issues FOMC Statement”.
- U.S. Department of the Treasury. “Daily Treasury Yield Curve Rates”.
- European Central Bank. “How Quantitative Easing Works”.
- European Central Bank. “ECB Introduces a Negative Deposit Facility Interest Rate”.
- Trading Economics. “Japan Interest Rate”.
- Bank of Japan. “Introduction of Quantitative and Qualitative Monetary Easing with a Negative Interest Rate”, Page 1.
- Federal Reserve Bank of New York. “Lessons at the Zero Bound: The Japanese and U.S. Experience”.
