The United States, Japan and several European Union member nations have turned to unconventional means to stimulate economic activity in the years following the Great Recession. Economists believe aggressive monetary policy is integral to the recovery process after a financial crisis. After two decades of slow growth, the Bank of Japan decided to employ a zero interest rate policy (ZIRP) to combat deflation and promote economic recovery. A similar policy has been implemented by the United States and United Kingdom.
- A zero interest rate policy (ZIRP) is when a central bank sets its target short-term interest rate at or close to 0%.
- The goal is to spur economic activity by encourage low-cost borrowing and greater access to cheap credit by firms and individuals.
- Because nominal interest rates are bounded by zero, some economists warn that a ZIRP can have negative consequences such as creating a liquidity trap.
ZIRP is a method of stimulating growth while keeping interest rates close to zero. Under this policy, the governing central bank can no longer reduce interest rates, rendering conventional monetary policy ineffective. As a result, unconventional monetary policy such as quantitative easing is used to increase the monetary base. However, as seen in the Eurozone, over-extending a zero interest rate policy can also result in negative interest rates. Thus, many economists have challenged the value of zero interest rate policies, pointing to liquidity traps amongst several other pitfalls.
If central banks decide to act even further, they can set an implied negative interest rate, where loans actually receive interest. This emergency measure would be a negative interest rate policy, or NIRP.
ZIRP was first used in the 1990s after the Japanese asset price bubble collapse. Japan implemented ZIRP as part of its monetary policy during the subsequent 10 years – commonly referred to as the Lost Decade – in response to declines in asset prices. Consumption and investment remained optimistic through 1991, GDP growth rate was higher than 3 percent, and interest rates held steady at 6 percent. However, as stock prices plummeted in 1992, GDP growth stagnated and deflation ensued. The consumer price index, which is often used as a proxy measure for inflation rates, declined from 2 percent in 1992 to 0 percent by 1995, and period interest rates fell drastically, approaching 0 percent that same year.
As a result of ZIRP’s inability to address stagnation and deflation, the Japanese economy fell into a liquidity trap. Despite the relative ineffectiveness of zero interest rates, Japan continues to use this policy.
The 2008 financial crisis caused deep financial strains in the U.S., leading the Federal Reserve to take aggressive actions to stabilize the economy. In an effort to prevent an economic collapse, the Federal Reserve implemented a number of unconventional policies, including zero interest rates to reduce short- and long-term interest rates. The subsequent increase in investments is expected to have positive effects on unemployment and consumption.
In 2009, the U.S. reached its lowest economic point following the financial crisis with inflation of -2.1 percent, unemployment at 10.2 percent, and GDP growth plummeting to -2.54 percent. Interest rates dropped to near zero during this period. By January 2014, after roughly five years of ZIRP and quantitative easing, inflation, unemployment, and GDP growth reached 1.6 percent, 6.6 percent, and 3.2 percent, respectively. Although the U.S. economy continues to improve, Japan’s experience suggests long-term usage of ZIRP can be detrimental.
During the 2020 global economic crisis, interest rates again approached the zero bound as investors fled to safety, with even longer-term U.S. Treasuries of 10 and 30 years falling below 1% to record low yields.
Despite the U.S.’s progress, economists cite Japan and EU nations as examples of the failures of ZIRP. Low interest rates have been attributed to the development of liquidity traps, which happens when saving rates become high and render monetary policy ineffective. Implementation of zero interest rates has mostly taken place after an economic recession when deflation, unemployment and slow growth prevail. Diminished investor confidence or mounting concern over deflation can also lead to liquidity traps. Additionally, despite zero interest rates and monetary expansion, borrowing can stagnate when corporations pay down debt from earnings rather than choosing to reinvest in the company.
ZIRP can also lead to financial turmoil in the markets during periods of economic stability. When interest rates are low, investors seek higher yield instruments that are generally associated with riskier assets. In the early 2000s, U.S. investors facing similar conditions chose to invest heavily in subprime mortgage backed securities (MBS). Due to Fannie Mae and Freddie Mac’s involvement with MBS, investors perceived these securities as secure with relatively high returns. However, as history has shown, mortgage backed securities were an integral piece leading to the Great Recession.
Interest rates play a key role in the financial market, possibly dictating saving of investment habits in the short- and long-term. Typically, long-term investments come in the form of retirement plans and pension funds. When long-term interest rates approach zero, the income of retirees and those approaching retirement fares worse.
Although ZIRP can be detrimental, policymakers in advanced economies continue to use the approach as a post-recession remedy. The primary benefit of low interest rates is their ability to stimulate economic activity. Despite low returns, near-zero interest rates lower the cost of borrowing, which can help spur spending on business capital, investments and household expenditures. Businesses’ increased capital spending can then create jobs and consumption opportunities.
Likewise, low interest rates improve bank balance sheets and the capacity to lend. Banks with little capital to lend were hit particularly hard by the financial crisis. Low interest rates can also raise asset prices. Higher asset prices combined with quantitative easing can increase the monetary base, resulting in an increase in household discretionary income.
ZIRP has been implemented in the wake of several economic recessions over the last two decades. First used by Japan in the 1990s, ZIRP has been widely criticized and deemed generally unsuccessful. However, despite Japan’s miscues with monetary policy, the U.S., the U.K. and EU nations have turned to ZIRP and quantitative easing to stimulate economic activity. Even with some success in the short term, long-term use of very low interest rates can lead to adverse effects, including the dreaded liquidity trap.
View more information: https://www.investopedia.com/articles/investing/031815/what-zero-interestrate-policy-zirp.asp