zero lower bound
/ ZLB /
When the economy slumps, the central bank's go-to remedy is to cut interest rates to encourage borrowing and spending. But there is a floor under how far it can cut. Why? Because cash exists. If a bank tried to charge you a deeply negative interest rate on your deposits, you would just withdraw your money and hold paper cash, which pays zero. So zero acts as a natural floor on interest rates — the zero lower bound. Once the policy rate is near zero, the bank's main tool is jammed and it cannot simply cut its way out of a downturn.
More precisely, economists now speak of an 'effective lower bound' that may sit a little below zero, because holding huge amounts of physical cash has storage and security costs. A few central banks (in Europe and Japan) actually pushed policy rates modestly negative — say minus 0.5 percent — to nudge banks to lend rather than hoard reserves. But you cannot go very far negative before people flee into cash, so the bound is real even if it is not exactly at zero. The deeper problem is that what matters for the economy is the real interest rate (nominal rate minus expected inflation); when inflation is very low or negative, the lowest real rate the bank can deliver may still be too high to revive demand.
The zero lower bound is one of the central dilemmas of modern macroeconomics. It was largely theoretical until Japan hit it in the 1990s and most rich-country central banks slammed into it after 2008. With the conventional lever stuck, banks turned to unconventional tools: quantitative easing, forward guidance, and modestly negative rates. The bound is also why some economists argue for a higher inflation target — a 4 percent target leaves more room to cut rates before hitting zero than a 2 percent one does.
After the 2008 crash, the Fed cut its policy rate essentially to zero and kept it there for seven years — having run out of room to cut further, it had to switch to QE and forward guidance to provide more stimulus.
At the zero bound the usual rate-cutting lever runs out of room.
The floor is set by the existence of physical cash, not by a rule, which is why mildly negative rates are possible; but deeply negative rates are not, because everyone would switch to holding banknotes.