The bane of the Zero Lower Bound

For more than 20 years, at a time when inflation had been low and stable for more than a decade, central banks began to discuss “Monetary Policy in a Low Inflation Environment”. Several conferences and papers on the issue followed. This one, from 2000, has a readable discussion and plenty of references. The abstract reads:

One of the most striking macroeconomic phenomena in recent decades has been the achievement of rather low and more stable rates of inflation in many countries in the nineties. Consequently, the main goal of this paper is to offer an overview of the main policy issues arising in a low inflation environment and their practical relevance so as to identify the main challenges facing central bankers in such an environment.

The paper asks the following questions: To what extent are the public’s attitudes towards price stability relative to other economic objectives -like unemployment- likely to change over time? How can the effectiveness of monetary policy change as a result of the nonlinearities associated with the zero bound on nominal interest rates, the supposedly higher degree of downward real wage rigidity and. in general. the presence of downward nominal wage or price rigidities? What does the low inflation environment imply about the relative importance and effects of supply shocks, “non-monetary” demand shocks and “monetary” demand shocks? What sort of indicators are like to be more useful to the central bank for assessing inflationary pressures and. in particular, should asset prices play a bigger role in the conduct of monetary policy?

In 1999, the Federal Reserve System sponsored a Conference on “Monetary Policy in a Low Inflation Environment”. In 2010 we have “Revisiting Monetary Policy in a Low Inflation Environment”. Eric Rosengren, president of the Boston Fed hosted the conference. In his concluding remarks, we read:

This conference, more than 10 years after our earlier conference on the topic, has benefitted from the additional experience that countries around the world have had, in the interim, with monetary policy in a low inflation environment. I would summarize by saying that clearly, conducting monetary policy in a low inflation environment is difficult – and particularly so when that low inflation environment also includes wrenching financial difficulties and stubbornly high unemployment rates. At our earlier conference, there was probably too little appreciation of the potential challenges, and too low a weight placed on how a low inflation environment could be hampered by the zero lower bound on short-term interest rates.

Now, after almost 10 years stuck at the ZLB (or close to it), central bankers keep trying to find a “way out”.

Some, like San Francisco Fed president John Williams, think the economy is “doing fine”:

Ladies and gentlemen, the economy is in a very good place. Unemployment is low and confidence is high. While low inflation remains a challenge for someone in my position, I imagine most of you aren’t overly concerned about a 1.6 percent inflation rate!

As we wrap up 2017 and look ahead to 2018, the problems we face are good ones: How to keep the economic expansion going, how to bring inflation up to its 2 percent target, and how we use this period to normalize monetary policy in general and interest rates in particular.

Others, like Chicago Fed president Charles Evans, think a change in the monetary policy framework is necessary:

Specifically, I will talk about Delphic communications as those associated with a well-functioning, well-understood monetary policy framework. A foundation for these communications is a variety of state-contingent responses to economic developments that are well understood and well expected by the public.

I’ll refer to Odyssean communications as those arising when unexpected events expose weaknesses and shortcomings in a Delphic framework. In such times, the need for outcome-based policies is paramount, and policymakers may be compelled to take less-well-understood actions to meet their mandated goals.

These actions may dispense with usual norms and could entail entirely new commitments about future central bank behavior. As such, these Odyssean policies might be difficult to communicate and might lack strong credibility. These shortcomings could dilute their effectiveness. So my question is this: How do you convert nonstandard Odyssean policies into a better-understood and more effective Delphic framework?

Well, you do so by strengthening your current monetary policy framework. Ben Bernanke’s recent proposal at the Peterson Institute for International Economics regarding temporary price-level targeting (PLT) is one such example.

Furthermore, the journey from the Fed’s 2010 policy debates about temporary price-level targeting at the zero lower bound (ZLB) to Bernanke’s recent proposal illustrates the challenges in transforming Odyssean policies into Delphic ones.

Although the focus has been on the “dangers” of reaching the ZLB due to low inflation, it appears that low inflation has no implication for the risk of reaching the ZLB. If that is true, there has been a lot of wasted time and effort.

The charts indicate that “low inflation” has no implication for the risk of reaching the ZLB.

If the risk of hitting the ZLB does not come from “low inflation”, where does it come from? The answer to that question is important because it would determine the appropriate monetary policy in a low inflation environment.

The charts below indicate that the risk of hitting the ZLB comes from monetary policy allowing the growth of nominal spending (NGDP) tank. Furthermore, for interest rates to rise, NGDP growth has to pick up enough to compensate for the previous drop!

The fact that the FF rate has started to rise, and is contemplated to rise further, has led David Beckworth to compare the Fed´s policy to the wrong medical treatment for hypothermia:

This story is an analogy of how the Fed has been handling inflation over the past decade. Just like falling into a freezing lake is a shock to your body temperature, the Great Recession was a shock to the inflation rate.

And just like you being stabilized in the ER, the economy was initially stabilized by the Fed. After being stabilized, though, your body temperature never fully recovered just like the inflation rate never returned on a consistent basis to 2%.

And just like the doctor seems to have forgotten the basics of body temperature, the Fed seems to have forgotten the basics of inflation. Moreover, the doctor is adding to his own confusion by turning up the air conditioner to cooler temperatures just as the Fed is increasingly perplexed as to why inflation remains low as it pushes up interest rates.

Since the big drop in the level of NGDP was never made up, and the rate of NGDP growth has remained low and stable, it is not surprising that we observe low and stable inflation and very low FF rate.

If too low NGDP growth (additionally at a low trend level) is the major reason for interest rates having difficulty moving up and away from the ZLB, the “best” monetary policy framework is NGDP Level Targeting, not, as some at the Fed are trying to advance, a higher inflation target or price level targeting.

The Fed, in pursuit of a misguided notion of “policy normalization” will end up leading the economy into recession.


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