In Search of the Effective Lower Bound


The Fed is no longer talking about zero-bound but effective lower bound. What's the difference? Where is it?

Change Observation

The self-described "BondFreak" noticed a shift in Fed vocabulary from "zero bound" to "effective lower bound".


Powell Ready to Cut Rates to "Effective Lower Bound" via "Conventional" Policy

A Google search for "effective lower bound" just happened to turn up my own post Powell Ready to Cut Rates to "Effective Lower Bound" via "Conventional" Policy.

Here are the pertinent statements from a speech Powell made on June 4 at a "Conference on Monetary Policy Strategy, Tools, and Communications Practices".

Emphasis is mine.

While central banks face a challenging environment today, those challenges are not entirely new. In fact, in 1999 the Federal Reserve System hosted a conference titled "Monetary Policy in a Low Inflation Environment." Conference participants discussed new challenges that were emerging after the then-recent victory over the Great Inflation. They focused on many questions posed by low inflation and, in particular, on what unconventional tools a central bank might use to support the economy if interest rates fell to what we now call the effective lower bound (ELB). Even though the Bank of Japan was grappling with the ELB as the conference met, the issue seemed remote for the United States.

The next time policy rates hit the ELB—and there will be a next time—it will not be a surprise. We are now well aware of the challenges the ELB presents, and we have the painful experience of the Global Financial Crisis and its aftermath to guide us. Our obligation to the public we serve is to take those measures now that will put us in the best position deal with our next encounter with the ELB.

The big difference between then and now is that the federal funds rate was 5.2 percent—which, to underscore the point, put the rate 20 quarter-point rate cuts away from the ELB. Since then, standard estimates of the longer-run normal or neutral rate of interest have declined between 2 and 3 percentage points, and some argue that the effective decline is even larger. The combination of lower real interest rates and low inflation translates into lower nominal rates and a much higher likelihood that rates will fall to the ELB in a downturn.

Why the shift?

I believe the answer is the Fed no longer believes zero is the ELB. So this leads to a different question.

Where the Heck is the ELB?

First, we need a definition.

What's the Definition of ELB?

Effective Lower Bound is the point beyond which further monetary policy in the same direction is counterproductive.

I propose the Bank of Japan and the ECB are already below ELB. I further propose the ELB can never be negative but it can be well above zero.

Reversal Interest Rate

I happened across an article just the other day on the ELB moving target.

Please consider The Reversal Interest Rate

The “reversal interest rate” is the rate at which accommodative monetary policy “reverses” its intended effect and becomes contractionary for the economy. It occurs when recapitalization gains from duration mismatch are more than offset by decreases in net interest margins, lowering banks’ net worth and tightening its capital constraint. The determinants of the reversal interest rates are (i) banks asset holdings with fixed (non-floating) interest payments, (ii) the strength of the constraints that they face, (iii) the degree of interest rate pass-through to deposit rates, and (iv) the initial capitalization of banks. Furthermore, quantitative easing increases the reversal interest rate and hence should only be employed after interest rate cut is exhausted. Over time the reversal interest rate creeps up, since the capital gains effect fades out as longterm bonds holdings mature while the net interest margin effect does not.

The authors propose the rate can be above or below zero but it gets higher over time especially if QE is involved.

Bank Lending Constraints

In our model, as in reality, the risk-taking ability of the banking sector is constrained by its net worth. If the latter is high enough so that the constraint does not bind, or if capital gains are strong enough to actually increase net worth, then an interest cut generates the boom in lending that the central bank seeks to induce. However, if capital gains are too low to compensate the loss in net interest income, net worth decreases to the point where the constraint binds, limiting banks’ ability to take on risk. At that point, i.e. at the reversal interest rate, any further interest cuts generate a decline in lending though the net-worth feedback. Moreover, an interesting amplification mechanism emerges. As the negative wealth effect further tightens banks’ equity constraint, banks cut back on their credit extension and are forced to increase their safe asset holdings. As safe assets yield lower returns, banks’ profits decline even more, forcing banks to substitute out of risky loans into safe assets, which in turn lowers their profit, and so on.


Huge Failure Already

I discussed lending constraints the other day (and many time priors) in ECB's New Interest Rate Policy "As Long As It Takes" Huge Failure Already

Banks Lend Under Two Conditions

  1. They are not capital impaired
  2. They believe they have good credit risks

If either condition is false, then banks don't lend.

Negative interest rates did not induce either Japanese or European banks to lend.

What's Going On?

Either European banks are more capital impaired than the ECB wants everyone to believe, or banks believe there are few good credit risks worth taking.

Take your pick. I expect both are true.

Stealth Recapitalization

We then uncover the determinants of the reversal interest rate in our baseline model. The reversal interest rate depends on bank assets interest rate exposure, the tightness of financial regulation, as well as the market structure of the banking sector. If banks hold more longterm bonds and mortgages with fixed interest, the “stealth recapitalization” effect due to an interest rate cut is more pronounced, and the reversal interest rate is lower. Stricter capital requirements rise the reversal interest rate. Lower market power, which decreases profits, also generates a higher reversal interest rate. For example, in a negative interest rate environment, innovations that allow depositors to substitute bank accounts for cash more easily hurt the banks’ margins and raise the reversal interest rate; if such innovation occurs below the reversal interest rate, it directly feeds back into lower lending.

The article mentions "stealth recapitalization" of banks. I have discussed that many times recently but in a different context.

The Fed pays interest on excess reserves but the ECB charges them. Whereas the Fed gave free money to banks, the ECB charged the banks for excess reserves it forced into the system.

Negative Interest Rates Are Social Political Poison

In contrast to the authors, I do not believe negative interest rate policy can ever work as it violates basis economic principles on time preference and the time value of money.

Moreover, a dive below the ELB supports the position I presented on September 23: Negative Interest Rates Are Social Political Poison

ELB Comments

  1. I like the notion of ELB, or Reversal rate if you prefer.
  2. I do not believe it can ever be below zero but accept the notion it can be higher.
  3. It is not fixed
  4. It varies bank-by-bank and changes over time

Chasing Tail Madness

Searching for the ELB is like chasing tails.

It's only by accident can a central bank catch the tail. But even if it does catch the tail, the tail can still move. Further efforts to re-catch the tail are as likely as not to be in the wrong direction.

With that, let's return to the BondFreak's question. Why the word change?

Perhaps the Fed is aware the ECB is on the wrong course, negative rates are counterproductive, or the ELB just might be above zero.

Perhaps it's meaningless happenstance.

Deeper Down the Rabbit Hole

Yesterday, I noted Draghi Open to MMT and a People's QE

Every attempt to fix the perceived problem of "too low inflation" goes deeper and deeper down the rabbit hole.

It's economic madness, yet, here we are.

The solution is to let the free market set interest rates rather than a tail-chasing consortium of economic wizards who have never spotted a bubble or a recession in real time.

Of, course, we also need to get rid of central banks and fractional reserve lending.

Got Gold?

Unfortunately, central banks will not vote to abolish themselves. It's also certain that government efforts to take direct control of money will be even worse than the actions of central banks.

A position is gold is the best counter to monetary policy madness.

Mike "Mish" Shedlock

Comments (32)
No. 1-15

How big a position in gold ? What percentage of overall portfolio. What say ye?



I suppose as much as you are comfortable sleeping with - but that could be too much. So up to 1/3

This is another idea

There are variations of the above - one needs to be comfortable wit it no matter what happens - otherwise you end up buying high and selling low - in any strategy


What about reflexivity?

As ELB achieved other items move and ELB moves too. It may not move back up but ski slope down.

Anyone clever enough to know what happens? Perhaps, but doubt they have much of a voice or will be supppressed if they do have a voice and the outcome they highlight is even more dystopian.


Hitting the ELB will not be a surprise they say.

Tacit admission all is not well (very bad) unless it's to appease Trump for 2020.

All this probably relies on some PhD model not tested in the heat of battle whilst 5000 years of tested history is ignored.

Is it me or is someone off the deep end? It's me, must be


Imagine a world.

Where banks were not bailed out.

Where QE never happened.

Where TARP never passed.

Where Jon Corzine was sent to jail. Where bankers went to jail.

Where ZIRP never was a policy.

Where the mortgage industry wasn't nationalized.

Where obama was a one term president.

How much better off we would be today.


The FED funds rate will never go negative. If every other central banks pushes rates negative, we should keep ours at say 1% and it will allow us to run huge deficits forever. The line for newly issued TBills will be enormous.


Trump’s Economic Program Has Left Most Americans Worse Off His tax cuts and tariffs are driving up prices and lowering wages. True? False? Convince me


I kindof suspect that an ELB can be negative in a Pol Pot scenario, where you can buy a bullet, or take a machete chop to the neck. At such times, investment strategy might not make good sense.

I wonder, though, if ELB could be negative in any other situation, or if the announcement of a negative ELB should be taken as a warning of intent.

[An ELB could dive negative for a short time depending on peoples' reaction rates -- but I don't think we're talking about that here.]

Tony Bennett
Tony Bennett

"If Powell doesn't want negative rates, why change the verbiage from "zero" to "effective" lower bound?"


Ha. I chided Powell for painting himself in the corner re: negative rates. I guess someone clued him in that Federal Reserve FOLLOWS the market ... does not lead.

Captain Ahab
Captain Ahab

At this point, how much of one's portfolio should be in gold is a question not easily answered. Conventional apportionment theory really does not address today's high-price/shrinking yield, near-zero interest rates, and excessive public/private debt, and the likely outcomes as economic growth slows.

The above question, in my mind, resolves to three scenarios. What is the probability of a stable/slow recovery relative to a pessimistic Great Implosion, or the optimistic rapid return to normative conditions (no substantial recession)? The higher the probability of a G-I, the higher the proportion of gold (for insurance) and cash (for bargain hunting).

The instigating factor(s) of the G-I could be any number of things. Bankruptcy of a major bank/company (GE anyone) could be enough for panic to set in. Once the lemmings start to run, they won't stop at the cliff.

Country Bob
Country Bob

Japan has been trying to push rates negative for decades. It doesn't work. Cash, gold and general house clutter all pay 0%, so there is never a reason to accept negative rates.

Fill your pantry with non-perishable food items -- all of which yields 0%.

Buy scrap metal -- it yields 0% also. The list if things one can buy that yield nothing is almost infinite. Why would anyone accept less than nothing?

Individuals don't accept it in Japan. JGBs are essentially sold at gun point (entities like Japan's post office are required to buy them by law). No reason to think anyone will voluntarily buy negative yielding Treasuries either. The ECB buying euro-trash isn't the same as European citizens buying it.

Meanwhile, pensioners really have nothing better to do with themselves but vote out the party that tries to steal their savings. How many prime ministers has Japan gone through since 1990? The LDP lost an election for the first time ever.

The Fed can dance and blow lots of smoke, but they aren't fooling anyone with their pseudo intellectualism. There is no reason for negative rates ever. It is a sign that a government is failing.


"In Search of the Effective Lower Bound"

In search of the ineffective lower bound.


He could mean they won't go negative or close to zero like they did before. From everything I've read about the current Fed chair, he was against going as low as they did during the financial crisis. I suspect rate cuts are going to come to an end quicker than people think and banks, bonds and other private investors will have to take a bath on their investments that reset in 2020 or have notes come due. Bondholders at WeWork aren't getting paid back. There are many companies like this.


You can pretend the economy is "booming",but the reality is the economy is far too weak for far too long for even ZIRP,which means NIRP and around the clock triage level money printing is the future...Fed is printing half a trillion a month desperate to keep the banks from complete collapse,that's the reality of the with it!

Country Bob
Country Bob

On average, the US economy is growing pretty nicely. On average. But if you stayed awake during your statistics classes, you may have heard the story about the old man in his kitchen. One foot in the oven, burning. One foot in the freezer, freezing. But on average, his feet are quite comfortable.

And so goes the US economy. Areas dependent on ever increasing piles of debt to cover continuous losses are in deep trouble. Areas that limited debt levels are doing quite well. On average the whole country is quite comfortable.

The Fed, as a central planning vehicle, has no tools to handle this bimodal distribution.... oh crap, I am writing this on a blog where many readers do not have the math background to understand what bi-modal means. Well, most of them are in the bankrupt category anyhow.

Powell has no way to fix the debt problem. Its not a money supply issue, its a debt issue. And lowering interest rates will only encourage the healthy parts of the economy to further side-step national banks. Local banks and local credit unions are doing MUCH better than the money center banks.

Negative rates won't happen in the USA for the same reason they didn't stick in Japan. NIRP neutered Japan's money center banks, which made the Bank of Japan impotent as well.

Central planners in the USA are doing the same dumb things, so they will get the same dumb results. Deal with it :)

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