What it means
Central banks usually respond to a weak economy by cutting short-term interest rates. Lower rates make borrowing cheaper, encourage spending and investment, and support jobs.
But if rates reach zero, cutting further becomes difficult. The main reason is that people and businesses could simply hold physical cash, which pays zero interest, instead of accepting a bank account that charges a negative rate.
This puts a floor under how low rates can go in practice. Some central banks have moved slightly below zero, which shows the floor is soft rather than absolute, but there is a limit to how far they can go.
When rates are stuck near zero, central banks use other tools. They can buy bonds on a large scale, called quantitative easing, to push down longer-term interest rates.
They can also give forward guidance, which is a public commitment to keep rates low for a long time. For business and finance teams, the zero bound changes the environment in several ways.
Borrowing costs are low, but bank deposit returns are also very low, which hurts savers and pension funds. Asset prices such as shares and property tend to rise when returns on cash are minimal.
The nuance is that the real interest rate, which is the nominal rate minus inflation, can still be negative or positive. At a zero nominal rate with 2% inflation, the real rate is minus 2%, which is mildly stimulating.
If inflation falls to zero or turns negative, a zero nominal rate becomes a positive real rate, and the economy can be tightened without the central bank intending it.
In practice
Real-world examples.
Example
A mid-sized manufacturer wants to build a new $15,000,000 plant while the central bank's rate is at the zero bound. It borrows at a fixed 3.5%, which is low by historical standards. The finance director locks in the rate for 10 years before conditions change.
Example
A pension fund holds government bonds yielding close to zero. It struggles to meet promised payments, because its liabilities are discounted at low rates and have grown larger. The trustees ask the sponsor to contribute an extra $4,000,000.
Example
A property investor sees the price of apartment blocks rising because cash earns nothing. She compares the rental yield with a zero return on deposits and decides to buy a block for $6,000,000. Her adviser warns that prices may fall when rates rise.
Formula
Calculation
Real interest rate = Nominal interest rate - Expected inflation
Shortfall in stimulus = Desired policy rate - Actual rate at the bound
A central bank's model suggests a policy rate of -3% would be right for a deep downturn, but the actual rate cannot go below 0%. The shortfall is 0% - (-3%) = 3 percentage points of missing stimulus. With a nominal rate of 0% and expected inflation of 2%, the real rate is 0% - 2% = -2%. If expected inflation fell to -1%, the real rate would be 0% - (-1%) = 1%, which tightens conditions just as the economy needs help.Case study
Seen in the real world.
Northgate Savings is an illustrative, fictional bank in a country where the central bank has cut its policy rate to zero. The bank's deposits cost almost nothing, but its loans are priced off a rate that is also close to zero, so its margin is squeezed. The treasurer notes that the interest margin has fallen from 3.0% to 1.8%.
The board considers charging customers for deposits but fears losing them to competitors and to cash. Instead, it raises fees on current accounts and cuts costs, saving $12,000,000 a year. It also lengthens the maturity of its loan book, accepting more risk for a higher yield.
In the illustrative outcome, the bank survives the period but earns less. The lesson is that the zero bound affects not only the central bank but every business that borrows, saves or lends, and treasurers plan for it ahead of time.
Watch out
Common mistakes.
- Believing rates can never go below zero, when some central banks have set slightly negative rates, though there are limits.
- Treating a zero nominal rate as free money, when the real rate depends on inflation and may be positive.
- Assuming the central bank has no tools left, when it can use bond buying, forward guidance and other measures.
Questions
People also ask.
Why can't rates fall much below zero?
Because depositors could withdraw and hold cash, which pays zero, so deep negative rates would trigger a flight to cash.
What is quantitative easing?
It is the large-scale purchase of bonds by a central bank to lower longer-term interest rates and support lending.
How does the zero bound affect companies?
It lowers borrowing costs but also squeezes returns on cash and bank margins, so planning must account for both.
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