ZIRP (Zero Interest-Rate Policy)

The zero interest-rate policy (ZIRP) is a monetary policy maintaining nominal short-term interest rates at zero. The global financial crisis that began in 2007 prompted the major central banks to take unconventional policy measures (although the ZIRP was first used by Japan in the 1990s). One of them was the reduction of short-term interest rates to about zero. The Fed slashed the federal funds rate to about zero in December 2008 and maintained it at such level until December 2015 (see the chart below). However, that hike was modest, so it did not normalize the level of interest rates.

Chart 1: Federal funds rate from January 1999 to January 2016.

The aim of the ZIRP was to stimulate economic activity thanks to zero interest rates, however, it caused many negative effects. Interest rates near zero evaporated the income of insurance companies and pensions funds. They also diminished the investors’ confidence, discouraged restructuring among commercial banks and indebted companies, and encouraged excessive borrowing (including governments). The ZIRP led investors to more risk-taking in order to seek higher yield instruments, creating asset bubbles and financial instability. It also made the central bank no longer able to reduce nominal interest rates.

Zero Interest-Rate Policy and Gold

Since the price of gold is negatively correlated with real interest rates, ZIRP was initially positive for the gold market. Bullion usually shines when real interest rates are low, or even negative, and are declining. Moreover, the ZIRP was considered an act of desperation, so it generated safe-haven demand for the yellow metal. However, the ZIRP pushed up also other asset markets, creating alternatives for gold. The chart below shows a significant positive correlation between the price of 10-year inflation-indexed Treasuries and the price of gold. In other words, it also shows a negative relationship between gold and real interest rates (the 10-year inflation indexed Treasury rate is a proxy of U.S. long-term real interest rate). The rates in the chart are in reverse order to show the trend in bond prices (which are inversely related to yields). As one can see, the price of gold is affected mainly by real long-term, not short-term, interest rates. This is why gold decisively entered a bear market in 2013.

Chart 2: 10-Year Inflation-Indexed Treasury Rate (in percent, green line, left axis, values in reverse order) and the price of gold (yellow line, right axis, London P.M. Fixing)

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