Effective lower bound

What Is Effective Lower Bound?

The effective lower bound (ELB) is a concept in monetary economics that refers to the lowest interest rate a central bank can set without causing adverse effects on the economy and financial system. It is a critical consideration in monetary policy, particularly during periods of low inflation or deflation, when central banks seek to stimulate economic activity by lowering interest rates. While the theoretical lower bound for nominal interest rates is often considered zero, the ELB acknowledges that practical limitations and unintended consequences can arise when rates approach or fall below this level.

History and Origin

The concept of a lower bound on interest rates gained prominence after Japan's "lost decades" of economic stagnation and deflation in the 1990s, where the Bank of Japan faced challenges in stimulating the economy despite near-zero interest rates. However, the effective lower bound became a prominent feature of the monetary policy environment for many developed economies following the 2008 global financial crisis and the subsequent period of low inflation and slow growth. Central banks, including the Federal Reserve and the European Central Bank (ECB), reduced their policy rates to historic lows, with some even venturing into negative territory.¹⁷

For instance, the ECB gradually reduced its deposit facility rate into negative territory, reaching -0.50% by September 2019.¹⁶ This period highlighted the challenges central banks face in stimulating economies when conventional interest rate tools are constrained by the ELB.¹⁵ The experience underscored that there's a limit to how much negative interest rates can be passed on to depositors without prompting them to withdraw cash, which could disrupt financial stability and impair the transmission of monetary policy.¹⁴

Key Takeaways

• The effective lower bound (ELB) represents the lowest nominal interest rate a central bank can set without triggering undesirable economic or financial consequences.
• It is generally below zero but not infinitely negative, as substantial negative rates can encourage cash hoarding and harm bank profitability.
• When the ELB is reached, central banks often resort to unconventional monetary policy tools, such as quantitative easing and forward guidance.
• The ELB poses a challenge to central banks' ability to combat deflation or persistently low inflation, as their capacity to stimulate the economy through rate cuts is limited.
• The level of the ELB can vary across economies and can be influenced by factors such as the public's preference for cash and the degree of financial euroization.¹³

Formula and Calculation

The effective lower bound does not have a single, universally accepted formula, as its precise level is not a fixed number and can vary based on economic conditions, institutional factors, and public behavior. Instead, economists and central banks often estimate the ELB through various models and empirical observations, considering factors like:

• Cost of holding cash: The logistical costs and risks associated with holding large amounts of physical currency.
• Bank profitability and lending: The point at which negative interest rates severely impair bank profitability, leading to a contraction in credit supply.
• Public's response to negative rates: The behavioral threshold at which individuals and firms start withdrawing deposits and converting them into cash to avoid negative remuneration.

Research into the ELB often involves assessing these factors to determine the point at which further rate cuts become counterproductive. For example, some studies estimate the ELB to be around -0.5% or lower based on empirical evidence from various countries and regions that have implemented negative interest rate policies.¹²

Interpreting the Effective Lower Bound

Interpreting the effective lower bound involves understanding its implications for monetary policy transmission and a central bank's ability to achieve its objectives. When the policy rate approaches the ELB, the central bank's conventional tools for stimulating the economy, primarily adjusting the short-term interest rate, become less effective.¹¹ This can lead to a "liquidity trap" scenario where further reductions in interest rates fail to stimulate aggregate demand because economic agents prefer to hold cash rather than invest or spend.¹⁰

The ELB also implies an asymmetry in a central bank's ability to respond to economic fluctuations. While central banks are unconstrained in raising policy rates to counteract inflationary pressures, they become constrained by the ELB when attempting to lower rates to combat deflation or persistently low inflation.⁹ This asymmetry can lead to a downward bias in inflation expectations, making it more challenging for central banks to achieve their inflation targets.⁸

Hypothetical Example

Consider a hypothetical economy, "Econland," experiencing a prolonged period of low inflation and weak economic growth. The Central Bank of Econland (CBE) has already lowered its benchmark policy rate to 0.25%. Despite this, inflation remains stubbornly below its 2% target, and unemployment is high.

To provide further stimulus, the CBE considers lowering the policy rate into negative territory. However, CBE economists estimate that the effective lower bound for Econland is around -0.75%. This estimate is based on surveys indicating that if deposit rates were to fall significantly below this level, a substantial portion of the population would begin withdrawing their savings from banks and holding them as physical cash, leading to disruptions in the financial system.

If the CBE were to lower its policy rate to, say, -1.0%, it would risk triggering widespread cash hoarding, which could reduce the money supply available for lending, further depress economic activity, and undermine the stability of the banking system. Therefore, even though a nominal rate of -1.0% might theoretically offer more stimulus, the ELB of -0.75% acts as a practical limit, beyond which the intended positive effects of lower rates would be outweighed by severe negative consequences. This scenario illustrates how the ELB constrains conventional monetary policy tools, forcing the CBE to consider unconventional monetary policy alternatives.

Practical Applications

The effective lower bound has significant practical applications for central banks and financial markets:

• Monetary Policy Strategy: Understanding the ELB informs central banks' decisions on their monetary policy framework. When rates hit the ELB, central banks must deploy alternative tools such as quantitative easing (large-scale asset purchases) or forward guidance to provide additional economic stimulus. The Federal Reserve, for instance, heavily relied on these measures during and after the 2008 financial crisis and the COVID-19 pandemic.⁷
• Inflation Targeting: The ELB complicates inflation targeting strategies. The risk of hitting the ELB can lead to a downward bias in inflation expectations, making it harder for central banks to achieve their inflation targets sustainably.⁶ This has led to discussions about adopting alternative frameworks like average inflation targeting or price-level targeting to better manage expectations when the ELB is binding.
• Financial Stability: Monitoring the ELB is crucial for financial stability. Extremely low or negative rates, if pushed too far, can compress net interest margins for banks, impacting their profitability and potentially their ability to lend. This could pose risks to the banking sector and the broader financial system. The European Central Bank has noted that while negative rates initially supported bank lending, their side effects on bank profitability require careful monitoring.⁵
• Investment Decisions: For investors, awareness of the ELB affects decisions related to fixed income and cash management. In an environment where policy rates are near the ELB, the potential for further yield compression on short-term debt is limited. This can push investors into riskier assets in search of yield, altering portfolio construction strategies.

Limitations and Criticisms

While the effective lower bound is a widely accepted concept, it faces several limitations and criticisms:

• Uncertainty of its exact level: The precise value of the ELB is not fixed and can vary. It depends on numerous factors, including the costs of storing and insuring physical cash, public trust in the banking system, and the overall economic environment. As a result, central banks can only estimate its level, leading to uncertainty in policy decisions.⁴
• Behavioral responses: The ELB implicitly relies on certain behavioral assumptions, particularly regarding how individuals and firms respond to negative interest rates by converting deposits into cash. If these behaviors change (e.g., due to new technologies like digital currencies or shifting preferences), the ELB could change. For example, the introduction of a central bank digital currency (CBDC) could potentially shift the ELB, as it could alter the attractiveness of holding physical cash.³
• Impact on financial intermediaries: Critics argue that negative interest rates, even if above the ELB, can negatively impact the profitability of financial intermediaries, especially banks that rely heavily on traditional deposit funding. Sustained pressure on bank profitability might reduce their capacity to lend, thus undermining the very stimulus monetary policy aims to achieve.²
• Distortion of asset prices: Prolonged periods at the ELB, combined with unconventional policies, can distort asset prices and lead to excessive risk-taking, potentially creating asset bubbles or financial imbalances.

Effective Lower Bound vs. Zero Lower Bound

The terms "effective lower bound" (ELB) and "zero lower bound" (ZLB) are often used interchangeably, but there is a subtle yet crucial distinction. The zero lower bound refers to the theoretical limit where nominal interest rates cannot fall below zero because holding physical cash offers a zero nominal return, providing an alternative to holding deposits that pay a negative rate.

In contrast, the effective lower bound acknowledges that real-world factors mean the practical lower limit for interest rates is typically below zero but not infinitely negative. This is because there are costs associated with holding, storing, and securing large amounts of physical cash (e.g., storage fees, insurance, security risks). Therefore, individuals and institutions would tolerate a small negative interest rate on their deposits before deciding to withdraw cash. The ELB is the point at which these costs outweigh the benefit of avoiding negative rates, making further rate cuts counterproductive due to the adverse effects on the banking system and broader economy.

FAQs

What happens when interest rates hit the effective lower bound?

When interest rates reach the effective lower bound, conventional monetary policy tools become limited. Central banks then typically resort to unconventional measures, such as quantitative easing (large-scale asset purchases) and forward guidance, to provide additional stimulus to the economy.

Why is the effective lower bound not always zero?

The effective lower bound is not always zero because holding physical cash incurs costs (e.g., storage, security, insurance). Therefore, banks and individuals are willing to accept a slightly negative interest rate on deposits before it becomes more economically rational to convert their holdings into physical currency. The exact level of the ELB can vary depending on these costs and other economic factors.

How does the effective lower bound affect inflation?

The effective lower bound can make it harder for central banks to achieve their inflation targets, particularly during periods of low inflation or deflation. When policy rates are constrained by the ELB, the central bank has less room to stimulate demand, which can lead to a downward bias in inflation expectations and make it challenging to bring inflation back to target.

Can quantitative easing overcome the effective lower bound?

Quantitative easing is an unconventional monetary policy tool used by central banks when the policy rate is at or near the effective lower bound. By purchasing large quantities of government bonds or other assets, central banks aim to lower long-term interest rates, increase liquidity in the financial system, and stimulate economic activity, thus providing additional stimulus beyond what can be achieved through policy rate adjustments alone.

What is the "reversal rate" in relation to the effective lower bound?

The "reversal rate" is a theoretical point, possibly below the effective lower bound, at which further reductions in negative interest rates would reverse their intended stimulative effect and instead harm bank profitability and reduce lending, ultimately becoming contractionary for the economy. While there is uncertainty about its precise level, the concept suggests that there is a limit to how deeply negative interest rates can go before becoming counterproductive.¹