What is Zero-Bound?

Zero-bound is a scenario in which the Federal Reserve lowers interest rates to zero or near zero. Traders sometimes also use the term to describe stocks that seem to be quickly losing value.

How Does Zero-Bound Work?

The Federal Reserve is the central bank of the United States. As a means of ensuring the safety of the nation's financial institutions, the Federal Reserve requires banks and other financial institutions to keep a strict percentage of their deposits on reserve at a Federal Reserve bank. The Federal Reserve determines the appropriate percentage, called the reserve requirement. If a bank is unable to meet its reserve requirement, it can borrow from the Federal Reserve to meet the requirement. The interest rate on these funds is called the discount rate. (Banks can also borrow the excess reserves of other banks, and this interest rate, called the federal funds rate, is determined by the open market. The Federal Reserve works to keep the discount rate close to the federal funds rate.)

The Federal Reserve could enact expansionary monetary policy and encourage economic growth by lowering the discount rate -- all the way to zero if necessary. Doing this creates a chain reaction. It becomes cheaper for banks to borrow money from the Federal Reserve, thus making it cheaper for banks to access funds they can in turn lend to customers.

Why Does Zero-Bound Matter?

The Federal Reserve can only lower interest rates so much. Accordingly, when it becomes zero-bound and the economy still needs stimulation, the Federal Reserve must use other methods. Some studies find that the alternatives to manipulating interest rates, however, aren't always as effective.

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Paul Tracy
Paul Tracy

Paul has been a respected figure in the financial markets for more than two decades. Prior to starting InvestingAnswers, Paul founded and managed one of the most influential investment research firms in America, with more than 3 million monthly readers.

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