Zero-Bound: Definition, Purpose, and How It Works

What is the zero-bound?

The zero-bound is the practical lower limit for short-term interest rates set by a central bank. When policy rates reach zero (or very close to it), conventional rate cuts can no longer be used to stimulate economic activity. This constraint can leave policymakers facing a liquidity trap, where low rates fail to revive demand.

Why it matters

• Interest-rate changes are a primary tool for central banks to cool or stimulate the economy.
• Hitting the zero-bound limits that traditional monetary policy can achieve.
• When the zero-bound is reached during weak economic conditions, central banks must use unconventional measures to provide further stimulus.

How central banks respond

When policy rates approach zero, central banks typically resort to alternative tools, including:
– Quantitative easing (QE): large-scale purchases of government bonds and other assets to lower longer-term interest rates and encourage borrowing.
– Forward guidance: signaling future policy intentions to shape expectations and influence longer-term rates.
– Credit-easing and targeted lending programs: supporting specific markets or sectors to restore functioning credit channels.

Negative interest rates

Faced with prolonged slow growth after the 2008 financial crisis, several central banks went further than the zero-bound and adopted negative interest rate policies (NIRP). Under NIRP, certain bank balances are charged rather than earning interest, effectively pushing nominal rates below zero to incentivize spending and lending.

Examples:
– Sweden: the Riksbank cut rates into negative territory after the crisis.
– European Central Bank (ECB) and Bank of Japan (BOJ): both have used negative-rate settings at times.
– Switzerland: sustained negative target rates for much of the 2010s.

Potential effects and trade-offs:
– Encourages banks to lend and households/businesses to spend rather than save.
– Can compress bank profitability and encourage risk-taking.
– May prompt cash hoarding or distort financial markets if extended for long periods.

Case study: Switzerland

The Swiss National Bank (SNB) used negative rates not primarily to combat domestic recession but to limit appreciation of the Swiss franc. Switzerland is a global safe haven; a rising franc would harm exports. The SNB’s approach included:
– Charging negative rates on bank balances above a set threshold (so not all deposits are affected).
– Intervening in foreign-exchange markets to cap the franc’s strength.
The SNB has indicated it would move back toward zero only when it can raise rates without triggering excessive currency appreciation.

Risks and limitations

• Diminished returns for savers and pensions.
• Pressure on bank margins, potentially reducing credit supply if banks cut back.
• Uncertain effectiveness once deeply negative, and possible side effects on asset prices and financial stability.

Key takeaways

• The zero-bound is the lower practical limit of interest-rate policy; when reached, central banks must use unconventional tools.
• Quantitative easing, forward guidance, and targeted credit actions are common alternatives.
• Negative interest rates extend policy beyond zero and have been used by several central banks, with mixed effects and notable risks.
• Specific contexts matter: policy choices like Switzerland’s reflect currency-management goals as well as domestic conditions.