Sliding towards an alternative target

John Williams, president of the San Francisco Fed presented an interesting paper – Monetary Policy at the Zero Lower Bound – Putting Theory into Practice – at the launch of the Brookings Hutchins Center on Fiscal & Monetary Policy.

From the introduction:

It has been said, “An economist is a man who, when he finds something works in practice, wonders if it works in theory.”

The study of the zero lower bound (ZLB) on nominal interest rates is an example of precisely the opposite: economists first figuring out what works in theory and then seeing if it works in practice. Japan’s experience with price deflation and zero short-term interest rates beginning in the 1990s led to a flurry of economic research on the ZLB and its implications for monetary policy (see, for example, Benhabib, Schmitt-Grohé, and Uribe 2001; Eggertsson and Woodford 2003; Reifschneider and Williams 2000; and references therein). This research came to a number of concrete conclusions and policy prescriptions that influenced policymaking during and after the global financial crisis.

One conclusion from the precrisis research was that the ZLB was a problem that could potentially afflict any economy with a sufficiently low inflation target, but that the episodes at the ZLB would be relatively infrequent and generally short-lived. For example, Reifschneider and Williams (2000) found that under a standard Taylor (1993) monetary policy rule and a 2 percent inflation target, monetary policy would be constrained at the ZLB about 5 percent of the time, and ZLB episodes would typically last just one year. Other research came to even more sanguine conclusions regarding the likely effects of the ZLB, in part because that research was often predicated on an economic environment similar to the tranquil Great Moderation period of the 1980s and 1990s in the United States (see, e.g., Adam and Billi 2006; Coenen, Orphanides, and Wieland 2004; Schmitt-Grohé and Uribe 2007).

Second, this research identified monetary policy strategies that should be effective at reducing most of the adverse effects of the ZLB. Specifically, short-term rates should be cut aggressively when deflation or a severe downturn threatens (Reifschneider and Williams 2000, 2002). That is, do not “keep your powder dry.” In addition, short-term rates should be kept “lower for longer” as the economy recovers (Eggertson and Woodford 2003; Reifschneider and Williams 2000, 2002). In theory, the expectation of a sustained low level of short-term interest rates reduces longer-term yields and eases financial conditions more broadly. In these two ways, the maximal amount of monetary stimulus can be put into place quickly. Indeed, this research found that such strategies should, in most cases, be sufficient to nearly fully offset the effects of the ZLB on the economy.

Third, some researchers argued that unconventional policy actions such as central bank large-scale asset purchases (LSAP) of longer-term securities or foreign exchange can complement conventional policy actions by making financial conditions more favorable for growth even when short rates are constrained by the ZLB (Bernanke and Reinhart 2004; Bernanke, Reinhart, and Sack, 2004; McCallum 2000; Svensson 2001).

Of course, within a few years of this research being written, the ZLB went from being a theoretical concern to a very real practical problem for many central banks across the globe. The Bank of England, the Bank of Japan, the European Central Bank, and the Federal Reserve all brought their policy rates to their respective effective lower bounds in late 2008 or early 2009. Central banks quickly sought to put into practice many of the prescriptions that researchers had identified.

The experiences of the past six years provide a wealth of data on what works and what doesn’t, which theories have proved useful, and which need to be reconsidered. This essay reexamines the three key issues outlined above that research highlighted related to the ZLB, and ends by laying out three still unanswered questions for monetary policy in a world where the ZLB is an ongoing concern.

At the end he covers Unresolved Issues:

The experience of the past six years has demonstrated the valuable contributions of economic theory and research in thinking through abstract economic issues before they became reality. It has also provided a store of new information regarding the incidence and consequences of the ZLB. In particular, we have learned that the ZLB is a serious practical issue that is very likely to constrain policy in the future, and that there are implementable policy actions that can help offset some, if not all, of the deleterious effects from the ZLB.

Looking ahead, there remain a number of key unresolved issues related to the ZLB. Three come immediately to mind.

First, should central banks change their policy frameworks from inflation targeting to one of price-level or nominal-GDP targeting in order to better anchor expectations of future policy actions?

One lesson from the recent past is the difficulty in anchoring policy expectations when the short-rate is at the ZLB. Although quantitative forward guidance has proven a useful tool, it suffers from a number of limitations. Experience has shown that it is impossible to convey the full reach of factors that influence the future course of policy. As a result, forward guidance ends up being overly simplified and prone to misinterpretation. Moreover, forward guidance several years in advance may not be credible, especially in light of the change in policymakers over time. In theory, alternative frameworks such as nominal GDP targeting, if fully understood by the public, could help resolve these communication difficulties.

Finally, and most controversially, in light of the experience of the costs of the ZLB and central banks’ abilities to counter them, does the 2 percent inflation target adopted by many central banks provide a sufficient cushion to allow monetary policy to successfully stabilize the economy and inflation in the future?

On one side of the ledger, recent experience proves that the ZLB is a worse problem than previously imagined; consideration of the implications of the ZLB in the future will need to take this into account. On the other side, forward guidance, large-scale asset purchases, and, in some cases, fiscal policy have proven to be effective partial antidotes for the ZLB. Even if one views the risks from the ZLB to be greater than before, there are alternatives to raising the inflation target. More-effective financial regulation may diminish the potential for a severe crisis for the foreseeable future. And, as noted above, adoption of a price-level or nominal GDP targeting regime could potentially further reduce the costs of the ZLB.

What is needed now, like the surge in research on the ZLB in the decade before the crisis, is a new flurry of research on these issues that takes into account the lessons of the past six years, and helps provide concrete prescriptions for future policymakers.

Australia may constitute a good laboratory for empirical research. The RBA says:

In determining monetary policy, the Bank has a duty to maintain price stability, full employment, and the economic prosperity and welfare of the Australian people. To achieve these statutory objectives, the Bank has an ‘inflation target’ and seeks to keep consumer price inflation in the economy to 2–3 per cent, on average, over the medium term.

(Note: Both the headline and the core measure average 2.6% since IT was implemented, so one can say the RBA has fulfilled its inflation mandate. With no recession it seems economic prosperity and the welfare of the Australian people has not been ignored. And it has remained far away from the ZLB).

The real growth picture:

Australian Paradigm_0

The inflation picture:

Australian Paradigm_1

The unemployment rate picture:

Australian Paradigm_2

The NGDP level targeting picture:

Australian Paradigm_3

The policy rate picture (no ZLB):

Australian Paradigm_4

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