Monetary policy

What is the effective lower bound (ELB) on interest rates?

To stabilise inflation at its target, the central bank must try to keep real interest rates close to their natural level (see What is the economy’s natural rate of interest?). This means that, over time, the central bank’s nominal interest rate should hover around a value that is the sum of the natural rate of interest and the inflation target.

The euro area’s current real natural rate of interest is estimated to be negative, meaning that, in a low inflation environment, the European Central Bank (ECB) would sometimes have to set negative nominal interest rates to keep the real interest rate at its natural level. However, the ECB cannot lower interest rates into negative territory as much as it would wish. If the ECB were to lower rates to very negative levels and banks were to pass on part of those negative rates to their deposits, households could withdraw their savings in cash, causing a serious financial stability problem. Should banks keep their deposit rates at 0%, they would have negative net returns, their profitability would fall and, therefore, so would their financial intermediation capacity. In both cases, lowering interest rates beyond a certain negative level would actually have an adverse impact on credit supply, economic activity and inflation.

This example shows that there is a lower limit to the nominal interest that the ECB can set (known as the effective lower bound or ELB) beyond which the effects of further rate cuts would be harmful for the economy.

This limit implies that monetary policy is able to combat inflation (through interest rate hikes) more effectively than deflation or persistently low inflation (since interest rates cannot be lowered once they have reached their lower bound).

A lower natural rate of interest means that, on average, nominal interest rates are closer to their lower bound and therefore that central banks have less room for stimulating their economies through interest rate policy alone. That is why central banks have added new instruments to their monetary policy toolkit.