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 that aggressive monetary policy is integral to the recovery process after a financial crisis.
The Bank of Japan employed a zero interest rate policy (ZIRP) to combat deflation and promote economic recovery after two decades of slow growth. Similar policies have been implemented by the United States and the United Kingdom.
Key Takeaways
- A zero interest rate policy (ZIRP) occurs when a central bank sets its target short-term interest rate at or close to 0%.
- The goal of ZIRP is to spur economic activity by encouraging low-cost borrowing and greater access to cheap credit by firms and individuals.
- Nominal interest rates are bound by zero so some economists warn that a ZIRP can have negative consequences.
- One theory is that a ZIRP can create a liquidity trap.
Zero Interest
ZIRP is a method of stimulating growth while keeping interest rates close to zero. The governing central bank can no longer reduce interest rates under this policy, rendering conventional monetary policy ineffective. Unconventional monetary policy such as quantitative easing is used to increase the monetary base as a result.
But over-extending a zero interest rate policy can also result in negative interest rates as seen in the Eurozone. Many economists have challenged the value of zero interest rate policies, pointing to liquidity traps among several other pitfalls.
Central banks can set an implied negative interest rate where loans actually receive interest. This emergency measure would be a negative interest rate policy or NIRP.
Japan
ZIRP was first used in the 1990s after the Japanese asset price bubble collapsed. In response to declines in asset prices, Japan implemented ZIRP as part of itsmonetary policy during the subsequent 10 years, commonly referred to as the Lost Decade.
Consumption and investment remained optimistic through 1991. The GDP growth rate was higher than 3% and interest rates held steady at 6%. But GDP growth stagnated and deflation ensued as stock prices plummeted in 1992. The consumer price index, which is often used as a proxymeasure for inflation rates, declined from 2% in 1992 to 0% by 1995. Period interest rates fell drastically, approaching 0% that same year.
The Japanese economy fell into a liquidity trap as a result of ZIRP’s inability to address stagnation and deflation.
Japan continues to use this policy despite the relative ineffectiveness of zero interest rates.
The United States
The 2008 financial crisis caused deep financial strains in the U.S., leading the Federal Reserve to take aggressive action to stabilize the economy. The Federal Reserve implemented several unconventional policies in an effort to prevent an economic collapse, including zero interest rates. The subsequent increase in investments is expected to have positive effects on unemployment and consumption.
The U.S. reached its lowest economic point following the financial crisis in 2009 with inflation of-2.1%, unemployment at10.2%,and GDP growth plummeting to-2.6%. Interest rates dropped to near zero during this period. Inflation, unemployment, and GDP growth reached1.6%,6.6%,and3.2% respectively by January 2014 after roughly five years of ZIRP and quantitative easing.
Japan’s experience suggests long-term usage of ZIRP can be detrimental but the U.S. economy continues to improve
Interest rates again approached the zero bound as investors fled to safety during the 2020 global economic crisis with even longer-term U.S. Treasuries of 10 and 30 years falling below 1% to record low yields.
Risks
Economists cite Japan and EU nations as examples of the failures of ZIRP despite the U.S.'s progress.
Low interest rates have been attributed to the development of liquidity traps that occur 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 and mounting concern over deflation can also lead to liquidity traps. Borrowing can stagnate when corporations pay down debt from earnings rather than choosing to reinvest in the company despite zero interest rates and monetary expansion.
ZIRP can also lead to financial turmoil in the markets during periods of economic stability. Investors seek higher yield instruments that are generally associated with riskier assets when interest rates are low.
U.S. investors facing similar conditions in the early 2000s chose to invest heavily in subprime mortgage-backed securities (MBS). They perceived these securities as secure with relatively high returns due to Fannie Mae and Freddie Mac’s involvement with MBS. But mortgage-backed securities were an integral piece leading to the Great Recession, as history has shown.
Interest rates play a key role in the financial market, possibly dictating investment habits in the short- and long-term. Long-term investments typically come in the form of retirement plans and pension funds. The incomes of retirees and those approaching retirement age fare worse when long-term interest rates approach zero.
Benefits
ZIRP can be detrimental but 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. Near-zero interest rates lower the cost of borrowing despite low returns and this can help spur spending on business capital, investments, and household expenditures. Businesses’ increased capital spending can then create jobs and consumption opportunities.
Low interest rates likewise 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 and increase household discretionary income as a result.
How Does ZIRP Stimulate Economic Growth?
Proponents assert that ZIRP reduces the costs of borrowing money for individuals, businesses, and institutions. This is a natural prompt for entities to borrow more and to spend the funds they're borrowing, effectively pouring the money back into the economy. ZIRP creates economic activity across the board, particularly in the area of large purchases such as real estate or automobiles.
What Is a Bubble in Economics?
The Financial Industry Regulatory Authority (FINRA) defines an economic bubble as something that occurs when "the price of a product outpaces its fundamental value, sometimes for extended periods." But bubbles have a tendency to pop and this can create vast damage, depending on their size.
Real estate prices soared during the early 2000s and many homeowners borrowed heavily to fund purchases. They found themselves owing significantly more on their properties than they were worth when the Great Recession of 2008 caused that bubble to burst. U.S. homes collectively lost $6 trillion in value at that time.
What Are Fannie Mae and Freddie Mac?
Congress created Fannie Mae and Freddie Mac in 1938 as integral components of the U.S. mortgage market. As sources of financing, they serve to keep the market affordable and stable. They purchase mortgages from lenders, affording lenders the opportunity to finance more mortgages. The process is said to keep mortgage money flowing.
The Bottom Line
ZIRP has been implemented in the wake of several economic recessions over two decades. First used by Japan in the 1990s, ZIRP has been widely criticized and deemed generally unsuccessful. However, the U.S., the U.K., and EU nations have turned to ZIRP and quantitative easing to stimulate economic activity despite Japan’s miscues with monetary policy.
Long-term use of very low interest rates can lead to adverse effects even with some success in the short term, including the dreaded liquidity trap.
