Monday, May 27, 2024

Zero Interest Rate Policy (ZIRP)

ZIRP stands for “zero interest rate policy”.

ZIRP is a macroeconomic concept that describes conditions characterized by extremely low nominal interest rates.

It’s when a nation’s central bank pushes nominal interest rates to 0% for its short-term benchmark.

ZIRP is considered to be an unconventional monetary policy instrument and can be associated with slow economic growth, deflation, and deleveraging.

The goal of ZRIP is to spur economic activity by encouraging low-cost borrowing and greater access to cheap credit by firms and individuals.

What is ZIRP?

Under ZIRP, the central bank maintains a 0% nominal interest rate.

The ZIRP is an important milestone in monetary policy because the central bank is typically no longer able to reduce nominal interest rates.

It is at the zero lower bound.

Conventional monetary policy is at its maximum potential to drive growth under ZIRP.

ZIRP is very closely related to the problem of a liquidity trap, where nominal interest rates cannot adjust downward at a time when savings exceed investment.

A liquidity trap is when monetary policy becomes ineffective due to very low-interest rates combined with consumers who prefer to save rather than spend or invest in higher-yielding bonds or other investments.

The primary goal of ZIRP is the same as any period in which a central bank is dropping prevailing interest rates: to catalyze economic expansion as well as to boost inflation by disincentivizing the hoarding of cash, and instead incentivizing lending, spending, and investment.

What is Zero Lower Bound?

ZIRP represents an important milestone because it theoretically means rates can’t be dropped further, as the lower bound (zero) has been reached.

The zero lower bound problem refers to a situation in which the short-term nominal interest rate is zero, or just above zero, causing a liquidity trap and limiting the capacity that the central bank has to stimulate economic growth.

Because of this, the arrival of ZIRP is perceived to be a time in which central bankers have “run out of bullets,” because their primary tool for controlling monetary policy has essentially been neutralized.

ZIRP in several instances has transformed into NIRP (Negative Interest Rate Policy).

ZIRP in the U.S.

On Dec. 16, 2008, with the world economy overwhelmed by the Global Financial Crisis, then head of the U.S. Federal Reserve Ben Bernanke announced that the American central bank was lowering its benchmark target interest rate to nearly zero.

The announcement by Bernanke marked the first time in American history that the Fed had dropped interest rates to such a level and became the first time that the U.S. adopted a Zero Interest Rate Policy (ZIRP).

The Fed held rates near zero until 2015 (approximately 7 years) before the central bank finally said the economy was healthy enough to (slowly) start raising rates.

The Fed was able to raise short-term interest rates as high as 2.5% percent (from zero) during the years 2015-2019.

Fast-forward to the present, all that work on raising the interest rate environment back toward “normal” levels has been erased.

In response to the COVID-19 pandemic,  ZIRP officially returned to the U.S. as a defensive tactic aimed at helping to insulate the American economy from negative shocks related to the ongoing global coronavirus crisis.

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