Happy Wednesday! Remember, even the Fed’s most powerful tools have constraints!

IN ACTION

“So if you go back to 2020, what we had was we'd been at the effective lower bound for seven years. We never got rates above 2%. We were at 1.5% when the pandemic hit.” - Chair Powell, University of Chicago Monetary Policy Forum (March 7, 2025)

THE BASICS

The effective lower bound (often used alongside the zero lower bound) refers to a challenging situation for the Fed. The institution can cut interest rates to boost the economy, but what happens when rates reach their limit? The effective lower bound refers to the point at which the Fed has exhausted its primary stimulus tool by lowering interest rates to at or near 0%, restricting the central bank’s ability to boost economic activity.

WHY IT MATTERS

Interest rates affect the cost of borrowing. When the Federal Reserve cuts rates, the cost of borrowing decreases - encouraging investment and discouraging saving. This increase in spending can profoundly impact job creation and overall growth, making interest rate reductions the Federal Reserve’s go-to when the economy needs a jolt. However, once rates are near zero, the Fed can no longer rely on further rate cuts and must turn to non-traditional monetary policy tools to support the economy.

The United States has been at the effective lower bound during two periods: after the Great Recession (2008-2015) and during the COVID-19 pandemic (2020-2022). With rate cuts no longer an option, the Federal Reserve turned to large-scale asset purchases, known as quantitative easing (QE), during both periods to further support the economy. Despite the risks that came with QE (asset price inflation, increasing inequality, encouraging risk-taking), the Fed had limited tools while at the effective lower bound - demonstrating the constraints of traditional monetary policy.

2025 AND BEYOND

Earlier, you’ll have noticed reference to the zero lower bound (ZLB); the ZLB assumes a theoretical limit where interest rates cannot go below zero, while the effective lower bound acknowledges that rates could dip slightly below zero. However, the Fed has never employed negative rates, unlike the European Central Bank, Bank of Japan, and several other central banks. In 2020, there was some discussion of whether policymakers would pursue negative rates due to the magnitude of the crisis, but Chair Powell routinely dismissed the idea. With the current target range for the federal funds rate at 4.25% to 4.50%, the Fed has ample room to cut rates should the economy need support, but the option of negative rates remains an interesting consideration for future crises.

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