Latest / Monetary Policy Explained with Fexingo: Central Banks, Money Supply, and Interest Rates / Why Central Banks Are Watching the Zero Lower Bound Again
Transcript
- Lucas: So the Bank of Japan has had its policy rate at negative zero point one percent since 2016. That is nine years of living on the floor. And now the ECB is at zero percent on its deposit rate, and the Fed is at zero point seven five percent on the fed funds rate. Suddenly the zero lower bound is not ancient history. Luna: I remember a few years ago everyone was saying the ZLB was a relic of the past. That we'd learned to use negative rates and forward guidance to go below zero. Lucas: Right, and that's what makes this interesting. The conventional wisdom after 2015 was that central banks had tools to push rates well below zero. The Swiss National Bank went to minus 0.75 percent. The ECB went to minus 0.5 percent. It seemed like the floor had dropped out. Luna: But then the banking system started to complain. I remember reading about the 'reversal rate' concept. Lucas: Exactly. That's Markus Brunnermeier at Princeton. He coined the term — the reversal rate is the rate below which further cuts become contractionary instead of stimulative. Because banks' net interest margins get squeezed so hard they start cutting lending. Luna: So the ZLB isn't just a technical zero. It's more of a zone where policy stops working. Lucas: That's the key insight. The zero lower bound is not a hard floor at zero percent. It's a region — maybe between zero and minus one percent — where the costs of negative rates start to outweigh the benefits. And every central bank is trying to figure out where that region is for its own economy. Luna: The Bank of Japan has been in that region the longest. What did they learn? Lucas: They learned that negative rates alone aren't enough. They had to supplement with yield curve control, which they introduced in 2016. The idea was to cap long-term rates so that the whole yield curve stays low. But even then, the banking sector struggled. Japan's regional banks have been consolidating for years because they can't make money on lending. Luna: So the ZLB is really a problem for the transmission mechanism. If banks stop lending, the rate cut doesn't reach the real economy. Lucas: Exactly. And that's why the Fed is now, in mid-2026, conducting its framework review. The last review was in 2020, when they adopted average inflation targeting. But this time, the zero lower bound is front and centre. They're asking: if we hit the ZLB again, what do we do? Luna: Is there any evidence that the reversal rate is different for different countries? I mean, the Swiss banking system seemed to handle minus 0.75 percent okay. Lucas: It depends on the structure of the banking system. Switzerland has a few large banks that can offset margin compression with fee income. Japan has hundreds of small regional banks that rely almost entirely on net interest margin. So the reversal rate in Japan might be higher — closer to zero — than in Switzerland. That's one reason the BOJ has been so cautious. Luna: So when people say 'the ZLB is back,' they really mean 'central banks are running out of room to cut before they hit the reversal rate.' Lucas: That's exactly right. And the implications are huge for the next recession. If the Fed only has 75 basis points of room before hitting the effective lower bound, they can't cut rates the way they did in 2008 — when they cut from 5.25 percent to zero. They'll have to rely on quantitative easing, forward guidance, maybe yield curve control. All the tools that are less tested. Luna: And the fiscal side becomes more important too. Lucas: Absolutely. That's the other big lesson from Japan. When the BOJ hit the ZLB in the 1990s, fiscal policy had to do the heavy lifting. The same thing happened in the euro area after 2011. So central bankers are now saying: if we're going to be constrained by the ZLB, we need fiscal policy to be ready. Luna: But fiscal policy is political. Central banks are independent for a reason. Lucas: Right, and that's the tension. In the US, the Fed can't force Congress to pass a stimulus package. So they're left with tools that might be less effective. That's why the framework review is so important — they need to figure out, ahead of time, what the backup plan is. Luna: One of the ideas I've seen is raising the inflation target to create more room before hitting the ZLB. Lucas: That's the old argument from Olivier Blanchard and others. If the neutral rate of interest is lower than it used to be, then a two percent inflation target means the policy rate is closer to zero on average. If you raise the target to three percent or four percent, you get more room to cut. But the Fed has been very reluctant to go there, because it could de-anchor inflation expectations. Luna: So they're stuck between a rock and a hard place. Low inflation target means less room. Higher target risks credibility. Lucas: Exactly. And the ECB is in the same boat. Christine Lagarde has said they're reviewing their strategy, and the ZLB is a big part of it. They're even talking about whether to adopt a tiered reserve system like the BOJ has, to protect banks from the full brunt of negative rates. Luna: You know, this is one of those topics where the more you learn, the more you realise how much uncertainty there is. Central bankers don't really know where the reversal rate is. Lucas: They're feeling their way in the dark. And that's what makes this episode — actually, this whole show — so valuable. We get to dig into these questions that affect everyone's borrowing costs, savings rates, mortgage rates. And it's possible because a small group of listeners supports us directly. Luna: Yeah, we keep this show ad-free and independent. It's listener-funded. A handful of people chip in monthly at buy me a coffee dot com slash fexingo, and that's what makes this possible. Lucas: If you've been listening and getting something out of it, that's the honest way to keep it going. No pressure — just a fact. And it's genuinely appreciated. Luna: Alright, back to the ZLB. So if the Fed and ECB are both wrestling with this, what's the most concrete outcome we might see from the framework review? Lucas: I think the most likely outcome is a formal acknowledgment that the effective lower bound is higher than zero — maybe around 0.5 percent or 0.25 percent — and that they will use balance sheet tools more aggressively before rates get that low. So they might start QE earlier in a downturn, while rates are still positive. Luna: That would be a big shift from the 2008 playbook, where they cut rates to zero first, then did QE. Lucas: Huge shift. And it implies that the sequencing of monetary easing will change. We might see rate cuts and QE happening simultaneously in the next recession. The BOJ has been doing that for years, but for the Fed, it would be new territory. Luna: So the zero lower bound isn't just a technical concept. It's reshaping the entire crisis response playbook. Lucas: It is. And the next recession will be the first real test of these new tools. We should probably have a whole episode on the Fed's framework review when it concludes later this year. Luna: I'll hold you to that.