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The Zero Lower Bound

Explain why an interest rate cannot be cut far below zero, and what the Bank of England did once rate cuts ran out.

Before you start

What you'll be able to answer

  1. Why can an interest rate not go far below zero, and why did the Bank of England stop cutting above zero in 2009?
  2. What can a central bank do once its interest rate is close to zero?
  3. Did interest rates stay close to zero for long?

Where this sits

Quantitative Easing ยท this module is lit

  1. 1998The Bank of England Act gives interest rate decisions to a committee at the Bank; the Chancellor keeps the target
  2. Mar 2009Bank Rate is cut to 0.5 per cent, and the Bank starts buying government bonds with newly created money
  3. Aug 2013The Bank says it will not consider raising interest rates at least until unemployment falls to 7 per cent
  4. Mar 2020Bank Rate is cut to a new low
  5. Jan 2022The reserves created by the purchases reach their peak
  6. Sep 2022The Bank buys government bonds again, to stop forced selling by pension funds
  7. Oct 2022Inflation reaches its highest rate in four decades
  8. Nov 2022The Bank starts selling its bonds back, the first major central bank to do so
  9. Aug 2023Bank Rate reaches its peak after rises at consecutive meetings
  10. Apr 2026The Governor writes an open letter to the Chancellor after inflation overshoots the target

Bank Rate was cut close to zero in March 2009

On 5 March 2009 the Bank of England's Monetary Policy Committee met. Five months earlier Bank Rate had been 5 per cent. Five cuts later it stood at 1 per cent, output was still shrinking, and the Committee saw a real risk that inflation would fall below its 2 per cent target in the years ahead. The usual answer was another cut, and the nine members first argued over whether one would still do any good. Then they cut Bank Rate to 0.5 per cent.

Predict first

Why can a central bank not keep cutting its interest rate further and further below zero?

Cash puts a floor under interest rates

A central bank's interest rate changes what it costs to borrow and what savers earn, and a cut brings spending forward. Close to zero, each further cut gets harder to make, because savers always have another choice: banknotes, which pay no interest. If a bank paid much less than zero on deposits, savers would take their money out as cash rather than pay to leave it there.

So a slump that is deep enough can leave a central bank with little or no rate cut left to make, and it needs other tools. America's central bank, the Federal Reserve, cut its rate almost to zero in December 2008, less than three months before the Bank of England stopped cutting.

The Bank judged that further cuts could hurt lending

The Bank stopped above zero, and the main reason was the banks. Savings accounts already paid very little and could hardly go lower. Some borrowers' rates were tied by contract to Bank Rate, so each cut lowered what banks and building societies earned from those loans. Squeezed between the two, lenders would make less profit, and could afford to lend less. The Committee also worried that years of very low rates could damage the markets in which banks lend to each other.

Against that, a cut would still help a little, through the pound and through the prices of assets such as shares. The Committee weighed both sides, made one more cut, and stopped there. That stopping point was a judgement, and the Bank moved it lower in later years.