Thursday, October 11, 2012

Zero Lower Bound: When Interest Rates Can't Drop Any Further

Recently, a new issue has emerged in the unfolding drama of the global financial crisis. After four years of reducing interest rates and increasing money supply at central banks of virtually all of the world's major economies, both academia and the media have started to mention a new obstacle, the Zero Lower Bound.

The underlying challenge of the Zero Lower Bound is that because interest rates are at zero, they cannot usually be lowered any further. Moreover, the context is typically one in which the economy is sluggish and stimulus is needed. In such circumstances, monetary policy has to proceed by unconventional means. Otherwise, a liquidity trap might develop along the lines of the situation Japan has been stuck in for nearly two decades. The question is of particular relevance today, since both the ECB and Fed have had their policy rates hovering around zero since 2008-2009. 

The Policy Alternatives
In 2010, the ECB published a working paper outlining the two ways that ZLB can be confronted are via a change in the way monetary policy is conducted, or via stimulatory changes in fiscal policy. 

In any case, whenever ZLB has been confronted in the recent past, some unorthodox monetary measures have been tried, with varying degrees of success:

  • Quantitative Easing: This can always be done, no matter how low interest rates are. This has been recommended for the case of Japan.

  • Switching the way monetary policy is conducted. Switching to inflation targeting is the rhetoric of choice now. In the 1990s, it was exchange-rate targeting. The downfall of this approach is credibility. If markets don't buy the idea that the central bank will commit to either exchange rate targeting or inflation targeting, the plan will run into difficult terrain. Since it has taken central banks decades to build the credibility of their current low-inflation path, a change in course might be difficult to establish credibly. At least overnight. 

  • Changing the distribution mechanism. Last year, the Fed engaged in "Operation Twist", an effort to engage in quantitative easing by injecting liquidity along various points on the yield curve. 

  • Negative Interest Rates: During the Swedish crisis in 1991, the Swedish central bank forced policy rates into negative territory temporarily by charging banks a premium for storage of funds within the central bank, as well as for access to LOLR services. This encouraged banks to actually lend funds which they were being issued. 

  • Reliance on Fiscal Policy: Market confidence can also be affected by changes in revenue and expenditure. Unfortunately, during hard times, the capability of the state to credibly increase its expenditure is limited. This is especially the case where central banks have the commitment not to monetize deficits. 

During the WWI and WWII eras the British tried a somewhat different take on this approach. In 1914, for example,  Keynes recommended direct monetary intervention to compensate losses in the international trade finance sector caused by the sudden German embargo. In concept, the idea is similar to the US' Troubled Asset Relief Program, a fiscal measure to directly intervene in the failed derivative market in 2008-2009. 

Regardless of the approach (or combination of approaches) used, the issue of maintaining an expansionary stance in the face of ZLB is one of the more challenging issues in monetary economics and central banking. It may be quite some time before a policy consensus develops in this area. One thing is certain however: central banks will all need to develop adequate ZLB tactics at one point or another. 

Max Berre is an economist at the EDHEC-Risk Institute (Ecole Des Hautes Etudes Commerciales du Nord) who has worked as a sovereign debt expert at the Inter-American Development Bank in Washington and has taught financial economics at Maastricht University in the Netherlands.

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