Why a zero lower bound is constraining the Fed funds rate
Zero lower bound
Under a zero interest rate policy, the central bank maintains a 0% nominal interest rate. The central bank is no longer in a position to reduce its nominal interest rates—it is at the zero lower bound. Some economists believe that unconventional monetary policy such as quantitative easing can be effective at the zero lower bound, as is the case in the U.S.
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A “zero lower bound” 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.
When an economy is stuck at the zero lower bound, the central bank can only provide further stimulus through reduced real interest rates by raising inflation expectations. Now, if the Fed tightens as it normally does, so as to prevent any inflation overshooting, then it will continue the long-run downward trend in nominal interest rates.
Inflation is one of the major causes of interest rate fluctuations in the economy. Certain exchange-traded funds (or ETFs) like the ProShares Investment Grade-Interest Rate Hedged ETF (IGHG), which has its major holdings in companies like Citigroup Inc. (C) and JP Morgan Chase & Co. (JPM), the Vanguard Short Term Corporate Debt ETF (VCSH), and the PowerShares Senior Loan Fund (BKLN), are designed to protect the investors against interest rate risk caused by inflation.
Charles Evans talked about the policy tools employed by the U.S. Fed in its current zero lower bound situation.
Large-scale asset purchases.
The Fed’s balance sheet over the years shows a marked increase in agency mortgage-backed securities, a result of the sub-prime crises, and Treasury securities, a result of quantitative easing.
Forward guidance on inflation and unemployment rates are being released
The Fed has stated its intentions to keep the Fed funds rate near zero—at least until the unemployment rate declines to lower than 6.5% or the inflation rate rises beyond 2.5%. However, the Fed has made it clear that these numbers should be treated as thresholds for considering a Fed funds rate increase, and not as triggers. The guidance also states that the Fed funds rate is likely to remain near zero, even if the unemployment rate in the economy lowers well past 6.5%—especially if the inflation rate continues to run below the target 2% level.
Incorporating unconventional tools such as maintaining a lower long-term interest rate also has an effect, but this is limited by economic conditionality.