Brookings Papers ON ECONOMIC ACTIVITY

BROOKINGS INSTITUTION PRESS

Contents

Editors' Summary..................................................................................................................................................................viiJOHN C. WILLIAMS Heeding Daedalus: Optimal Inflation and the Zero Lower Bound....................................................................................................1Comment by Michael Woodford.......................................................................................................................................................38General Discussion................................................................................................................................................................45SUMIT AGARWAL, JOHN C. DRISCOLL, XAVIER GABAIX, and DAVID LAIBSON The Age of Reason: Financial Decisions over the Life Cycle and Implications for Regulation.....................51Comments by Giovanni Dell'Ariccia and Karen M. Pence..............................................................................................................................102General Discussion................................................................................................................................................................111RICARDO REIS Interpreting the Unconventional U.S. Monetary Policy of 2007–09...............................................................................................119Comments by Timothy Besley and Donald L. Kohn.....................................................................................................................................166General Discussion................................................................................................................................................................176ROBERT E. HALL By How Much Does GDP Rise If the Government Buys More Output?.....................................................................................................183Comments by Alan J. Auerbach and Christopher L. House.............................................................................................................................232General Discussion................................................................................................................................................................244CARMEN M. REINHART AND VINCENT R. REINHART When the North Last Headed South: Revisiting the 1930s................................................................................251Comment by Chang-Tai Hsieh........................................................................................................................................................273General Discussion................................................................................................................................................................276

Chapter One

Heeding Daedalus: Optimal Inflation and the Zero Lower Bound

ABSTRACT This paper reexamines the implications for monetary policy of the zero lower bound on nominal interest rates in light of recent experience. The ZLB contributed little to the sharp output declines in many economies in 2008, but it is a significant factor slowing recovery. Model simulations imply that an additional 4 percentage points of rate cuts would have limited the rise in the U.S. unemployment rate and would bring unemployment and inflation more quickly to steady-state values, but the ZLB precludes these actions, at a cost of $1.8 trillion in forgone U.S. output over four years. If recent events presage a shift to a significantly more adverse macroeconomic climate, then 2 percent steady-state inflation may provide an inadequate buffer against the ZLB, assuming a standard Taylor rule. Stronger countercyclical fiscal policy or alternative monetary policy strategies could mitigate the ZLB's effects, but even with such policies an inflation target of 1 percent or lower could entail significant costs.

Icarus, my son, I charge you to keep at a moderate height, for if you fly too low the damp will clog your wings, and if too high the heat will melt them. —Bulfinch's Mythology, Chapter XX

Japan's sustained deflation and near-zero short-term interest rates beginning in the 1990s prompted an outpouring of research on the implications of the zero lower bound (ZLB) on nominal interest rates for monetary policy and the macroeconomy. In the presence of nominal rigidities, the ZLB will at times constrain the central bank's ability to reduce nominal, and thus real, interest rates in response to negative shocks to the economy. This inability to reduce real rates as low as desired impairs the ability of monetary policy to stabilize output and inflation. The quantitative importance of the ZLB depends on how often and how tightly the constraint binds, a key determinant of which is the steady-state inflation rate targeted by the central bank. If that rate is sufficiently high, the ZLB will rarely impinge on monetary policy and the macroeconomy. If sufficiently low, the ZLB may have more deleterious effects. All else equal, then, the presence of the ZLB argues for a higher steady-state inflation rate.

Of course, not all else is equal. Since Martin Bailey (1956), economists have identified and studied other sources of distortions related to inflation besides the ZLB. Several of these—including transactions costs, real distortions associated with nonzero rates of inflation, and non-neutralities in the tax system—argue for targeting steady-state inflation rates of zero or below. Others—including asymmetries in wage setting, imperfections in labor markets, distortions related to imperfect competition, and measurement bias—argue for positive steady-state inflation (see, for example, Akerlof, Dickens, and Perry 1996). Balancing these opposing influences, central banks around the globe have sought to heed the mythical Greek inventor Daedalus's advice to his son by choosing an inflation goal neither too low nor too high. In practice, many central banks have articulated annual inflation goals centered on 2 to 3 percent (Kuttner 2004). Simulations of macroeconomic models where monetary policy follows a version of the Taylor (1993) rule indicate that with an inflation target of 2 percent, the ZLB will act as a binding constraint on monetary policy relatively frequently (Reifschneider and Williams 2000; Billi and Kahn 2008). But these simulations also predict relatively modest effects of the ZLB on macroeconomic volatility with a 2 percent target, because the magnitude of the constraint will be relatively small and its duration relatively brief. Only with inflation targets of 1 percent or lower does the ZLB engender significantly higher variability of output and inflation in these simulations. In summary, these studies find a 2 percent inflation target to be an adequate buffer against adverse effects arising from the ZLB.

The economic tumult of the past two years, with short-term interest rates near zero in most major industrial economies, has challenged this conclusion. As figure 1 shows, the global financial crisis and ensuing recession have driven many major central banks to cut their short-term policy rates effectively to zero; other central banks constrained by the ZLB include the Swedish Riksbank and the Swiss National Bank. Despite these aggressive monetary policy actions, and despite considerable stimulus from fiscal policy, these economies are suffering their worst downturns in many decades (figure 2). In addition, fears of deflation have intensified as falling commodity prices and growing economic slack put downward pressure on prices generally. As figure 3 shows, overall consumer price index (CPI) inflation has fallen sharply in all major industrial economies. Much of this decline is due to falling commodity prices, especially energy prices, but core measures of CPI inflation have come down in these economies over the past year as well.

Given these conditions, a strong case can be made for the desirability of additional monetary stimulus in the United States and in many other countries. But with rates already effectively at zero, this is not an option, at least in terms of conventional monetary actions. Several central banks have therefore taken unconventional measures, such as changes in the composition and size of the asset side of their balance sheets. But the short- and long-term effects of these unconventional policies remain highly uncertain, and in any case such policies are at best imperfect substitutes for standard interest rate cuts.

This paper examines the effects of the ZLB on the current recession and reevaluates the expected future effects associated with the ZLB and the optimal inflation rate in light of new information and research. There are two main findings. First, the ZLB did not materially contribute to the sharp declines in output in the United States and many other economies through the end of 2008, but it is a significant factor slowing their recovery. Model simulations for the United States imply that an additional 4 percentage points of interest rate cuts would have kept the unemployment rate from rising as much as it has and would bring the unemployment and inflation rates more quickly to their steady-state values, but the ZLB precludes these actions. This inability to lower interest rates comes at a cost of about $1.8 trillion of forgone output over four years. Second, if recent events are a harbinger of a significantly more adverse macroeconomic climate than experienced over the past two decades, then a 2 percent steady-state inflation rate may provide an inadequate buffer against the ZLB having noticeable deleterious effects on the macroeconomy, assuming the central bank follows the standard Taylor rule. In such an adverse environment, stronger systematic countercyclical fiscal policy, or alternative monetary policy strategies, or both may be needed to mitigate the harmful effects of the ZLB with a 2 percent inflation target. Even with such policies, an inflation target of 1 percent or lower could entail significant costs in terms of macroeconomic volatility.

The paper is organized as follows. Section I examines the effects of the ZLB on the U.S. economy during the current episode. Section II reexamines the assumptions and results of past calculations of the macroeconomic effects of the ZLB under the Taylor rule. Section III evaluates alternative monetary and fiscal policies designed to mitigate the effects of the ZLB. Section IV concludes.

I. Lessons from the Current Recession

The ongoing global recession provides compelling proof that the ZLB can be a significant constraint on monetary policy, with potentially enormous macroeconomic repercussions. This section investigates two questions regarding the role of the ZLB in the current episode. First, how should one interpret the widespread phenomenon of central banks lowering their policy interest rates to near zero? Second, what are the consequences of the ZLB in terms of the depth of the recession and the speed of recovery?

The fact that central banks have found themselves constrained by the ZLB should not be surprising; in fact, one of the three main "lessons" offered by David Reifschneider and Williams (2000) was that central banks pursuing an inflation goal of around 2 percent would encounter the ZLB relatively frequently. For example, in a briefing paper prepared for the Federal Open Market Committee (2002) Reifschneider and Williams find that with a 2 percent inflation target, roughly in line with the practices of many major central banks, a calibrated version of the Taylor rule (1993) hits the ZLB about 10 percent of the time in simulations of the Federal Reserve Board's FRB/US macroeconometric model. Given that inflation has been centered around 2 percent in the United States since the mid-1990s, it was fully predictable that the ZLB would at some point become an issue—either as a threat, as in 2004, or as a reality, as it is today.

Indeed, the fact that many central banks have already run up against the ZLB is evidence that they have learned a second lesson from recent research, namely, that policymakers should not shy away from the ZLB, but should instead "embrace" it. A common theme in that research is that when the economy weakens significantly or deflation risks arise, the central bank should act quickly and aggressively to get interest rates down, to maximize the monetary stimulus in the system when the economy is weakening. "Keeping your powder dry" is precisely the worst thing to do. Figure 4 shows nominal and ex post real rates on short-term Treasury securities going back to the 1920s. Despite a low rate of inflation and three recessions, nominal interest rates did not once approach the ZLB in that decade. That the ZLB appears to be a greater problem today than in the 1950s and early 1960s, when inflation was also low, may reflect "better" monetary policy in the more recent period. Indeed, a comparison of estimated Taylor-type rules covering that period and the more recent past indicates that short-term interest rates were far less sensitive to movements in output and inflation during the earlier period (Romer and Romer 2002). Of course, the U.S. economy and financial system were very different 50 years ago, so other factors may also explain the differences in interest rate behavior.

To answer the second question, I conduct counterfactual simulations of the Federal Reserve's FRB/US model in which the Federal Reserve is not constrained by the ZLB.3 These simulations are best thought of as scenarios where the economy enters the current episode with a higher steady-state inflation rate, and therefore the Federal Reserve has a larger interest rate buffer to work with. I consider experiments in which the Federal Reserve is able to lower the federal funds rate by up to 600 basis points more than it has. For comparison, Glenn Rudebusch (2009) finds, based on an estimated monetary policy rule and Federal Open Market Committee (FOMC) forecasts, that in the absence of the ZLB the funds rate would be predicted to fall to about -5 percent. Again, these experiments are not real policy options available to the Federal Reserve. But they allow me to quantify the effects of the ZLB on the recent trajectory of the U.S. economy.

In evaluating the role played by the ZLB, it is important to get the timing of events right. Private forecasters did not anticipate until very late in 2008 that the ZLB would be a binding constraint on monetary policy. Figure 5 uses the consensus forecast reported in Blue Chip Financial Forecasts to show the expected path of the federal funds rate at various points in 2008 and 2009. At the beginning of September 2008—right before the failure of the investment bank Lehman Brothers and the ensuing panic—forecasters did not expect the funds rate to fall below 2 percent. It was not until early December 2008, when the full ramifications of the panic became clear, that forecasters came to anticipate a sustained period of rates below 1 percent, and the ZLB clearly came into play. In fact, the FOMC cut the target funds rate from 1 percent to a range of zero to 1/4 percentage point on December 16, 2008. A similar pattern is seen in forecasts of policy rates in other major industrial economies, whose central banks made their final rate cuts in December 2008 or in 2009.

The preceding argument is based on evidence from point forecasts, which typically correspond to modal forecasts. But in theory, economic decisions depend on the full distribution of the relevant forecasts, not just the mode. The possibility that the ZLB could bind in the future may have introduced significant downward asymmetry in forecast distributions of output and inflation in late 2008. Such an increase in the tail risk of a severe recession could have caused households and businesses to curtail spending more than they would have if the ZLB had not been looming on the horizon. Although the evidence is not definitive, forecasts in late 2008 do not appear to provide much support for such a channel. Prices for binary options on the federal funds target rate indicate that even as late as early November 2008, market participants placed only about a 25 percent probability on a target rate of 50 basis points or lower in January 2009. In addition, the distribution of forecasts for real GDP growth in 2009 from the Survey of Professional Forecasters (SPF) in the fourth quarter of 2008 does not display obvious signs of asymmetric downside risks.

In summary, the available evidence suggests that through late 2008, that is, until the ramifications of the financial panic following the failure of Lehman Brothers were recognized, forecasters did not view the ZLB as a binding constraint on policy. Therefore, it is unlikely that it had a significant impact on the major industrial economies before that time, outside Japan. Importantly, this is the period in which these economies were contracting most rapidly. According to monthly figures constructed by Macroeconomic Advisers, the period of sharply declining real U.S. GDP ended in January 2009, with declines of 2 percent in December 2008 and 0.7 percent in January 2009. Real GDP was roughly flat from January through July 2009.

Since early 2009, however, the ZLB has clearly been a constraint on monetary policy in the United States and abroad. Interestingly, forecasters and market participants expect that the ZLB will pose a relatively short-lived problem outside Japan. The dashed extensions of the lines in figure 1 show market expectations of overnight interest rates derived from interest rate futures contracts as of September 2009. At that time market participants expected major central banks except the Bank of Japan to start raising rates by early 2010. As shown in figure 5, the Blue Chip forecasters have likewise consistently predicted that the Federal Reserve would start raising rates after about a year of near-zero rates. Even those forecasters in the bottom tail of the distribution of the Blue Chip panel expected the ZLB to constrain policy for only about a year and a half. Based on these expectations that central banks will raise rates relatively soon, one might be tempted to conclude that the effects of the ZLB have been relatively modest. Arguing against that conclusion is the fact that four quarters is the mean duration that the ZLB constrained policy in the model simulations with a 2 percent inflation target reported in Reifschneider and Williams (2000), and that even such relatively brief episodes can inflict costs on the macroeconomy. Moreover, these forecasts of the path of interest rates may prove inaccurate.

I construct my counterfactual simulations starting from a baseline forecast set equal to the August 2009 SPF forecast (Federal Reserve Bank of Philadelphia 2009). The baseline forecast and the counterfactual simulations for short-term interest rates, the unemployment rate, and inflation (as measured by the core price index for personal consumption expenditure, PCE) are shown in figure 6. The SPF foresees the unemployment rate remaining above 7 percent through 2012 and core PCE inflation remaining below the median value of the FOMC's long-run inflation forecasts of 2 percent through 2011. Interestingly, this forecast has the core inflation rate rising over 2010–11, despite continued high unemployment. Such a forecast is consistent with a Phillips curve model of inflation in which inflation expectations are well anchored around 2 percent (Williams 2009). Note that these forecasts incorporate the effects of the fiscal stimulus and unconventional monetary policy actions taken in the United States and abroad.

I consider three alternative paths for the nominal federal funds rate and examine the resulting simulated values of the unemployment rate and the core PCE inflation rate. Given the evidence presented above that the ZLB was not a binding constraint until the very end of 2008, I assume in these counterfactual scenarios that additional nominal rate cuts of 200, 400, and 600 basis points occur in 2009Q1. I assume that the entire additional cut occurs in that quarter and that rates are held below the baseline values through 2010Q4, after which the short-term nominal rate returns to its baseline (SPF forecast) value. I assume no modifications of the discretionary fiscal policy actions and unconventional monetary policy actions that are assumed in the baseline forecast. I further assume that the monetary transmission mechanism works as predicted by the FRB/US model; that is, that the disruptions in the financial sector do not change the marginal effect of the additional rate cuts. Admittedly, these are strong assumptions, but I do not see better alternatives.

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