Effective lower bound

The effective lower bound, hereinafter used as a synonym for zero lower bound (ZLB) on nominal interest rates, describes a situation in which the policy-controlled short-run interest rate - to wit, the overnight repurchase agreement (repo) rate at which depository institutions borrow short-term funds from the central bank - is reduced to close to zero: to a level where it cannot be, for practical reasons, brought down any further.

In mainstream economics, the ZLB is deemed to pose a serious challenge to central banks, as it may push the economy into a "liquidity trap", which, in turn, cripples the effectiveness of monetary policy and renders the latter unable to achieve the macro- economic objectives of low and stable inflation and sustained economic growth. This is so as, once the ZLB on nominal interest rates has been reached, central banks have no other option but to substitute standard interest rate policies (based upon the control of the nominal short-term interest rate) with non-conventional monetary policy instruments, whose ultimate impact on economic activity is highly uncertain.

Though its significance was downplayed during the "Great Moderation" (Japan was regarded as a special case), the ZLB has come to the forefront of academic and policy debates in recent years, prompting a great deal of research on the subject matter (see Svensson, 2010; Williams, 2010; and references therein). Following the onset of the global 2008-09 financial crisis, major central banks around the world aggressively lowered their policy rates of interest to ward off deflationary pressures and shield the "real side" of the economy from potential disruptions arising in the financial system. Several leading central banks (the Federal Reserve (Fed) and the Bank of England (BoE) are cases in point) already found themselves constrained by the ZLB on nominal interest rates in the aftermath of Lehman Brothers' collapse in 2008. They were thus forced to rely exten- sively on alternative, non-conventional measures to prevent inflation expectations from falling to undesirably low (or even negative) levels and, hence, forestall a rise in the ex- ante real interest rate.

While various taxonomies exist, it is convenient to classify non-conventional meas- ures into three broad categories (see Bernanke et al., 2004, pp. 7-24). The first category includes measures aimed at shaping market participants' expectations of future short- term interest rates by providing explicit forward guidance as regards the future path of target interest rates and, hence, the monetary policy stance likely to prevail in the foresee- able future. At the apex of the financial crisis in 2008, several central banks signalled their intention to commit to low policy interest rates for an extended period of time. Some of them, like the Fed, have gone further, tying the "normalization" of interest rates to a specific time frame and, since December 2012, to the evolution of some relevant macro- economic variables, such as the rate of inflation and the unemployment rate (see Federal Open Market Committee, 2012).

The second and third categories of non-conventional measures encompass so-called "balance sheet policies", which seek to alter the size and/or composition of the central bank's balance sheet so as to put downward pressure on long-term interest rates and ease credit and financial conditions more generally. A distinction is drawn between "quantitative easing" policies (the second category), which focus primarily on increasing the size of the central bank's balance sheet through the expansion of bank reserves, paying little attention to the structure of the asset side; and "credit easing" policies (the third category) aimed at altering the composition of the asset side of the balance sheet in order to address disruptions in specific credit market segments and improve the availability of credit to the private sector (Bernanke, 2009). The large-scale asset purchase programme implemented by the Fed since late 2008, through which it has purchased large amounts of private and government assets, can be regarded as part of its "credit easing" policy.

Two other non-conventional measures have been proposed to alleviate the risk posed by the ZLB constraint. Notably, Blanchard et al. (2010) suggest potential benefits from raising the target inflation rate beyond the typical 2 per cent ceiling. Indeed, revising the inflation target rate (and inflation expectations) upward would be conducive to higher nominal interest rates, which, in turn, would provide central banks more leeway for conventional monetary policy easing before the ZLB on nominal interest rates is reached. On the other hand, Eggertsson and Woodford (2003) advocate price-level targeting as an effective means of creating expectations of higher inflation once an adverse shock hits the economy, thus mitigating the risk of hitting the ZLB. Whilst theoretically appealing, the relevance of these measures remains a matter of dispute. As a corollary to this, major central banks have refrained from either revising their target inflation rate upward or adopting a pre- determined price-level target after the inception of the 2008-09 financial crisis.

See also:

Carney, Mark; Corridor and floor systems; Financial crisis; Forward guidance; Inflation targeting; Interest rates setting; Liquidity trap; Policy rates of interest; Price-level target- ing; Quantitative easing; Repurchase agreement; Zero interest-rate policy.