Reflections on economics, finance, and policy by the former Chairman of the Federal Reserve, now Brookings Distinguished Fellow in Residence. The Brookings Institution is a nonprofit public policy organization based in Washington, DC. Our mission is to conduct in-depth research that leads to new ideas for solving problems facing society at the local, national and global level.
Low nominal interest rates, low inflation, and slow economic growth pose challenges to central bankers. In particular, with estimates of the long-run equilibrium level of the real interest rate quite low, the next recession may occur at a time when the Fed has little room to cut short-term rates. As I have written previously and recent research has explored, problems associated with the zero-lower bound (ZLB) on interest rates could be severe and enduring. While the Fed has other useful policies in its toolkit such as quantitative easing and forward guidance, I am not confident that the current monetary toolbox would prove sufficient to address a sharp downturn. I am therefore sympathetic to the view of San Francisco Fed President John Williams and others that we should be thinking now about adjusting the framework in which monetary policy is conducted, to provide more policy “space” in the future. In a paper presented at the Peterson Institute for International Economics, I propose an option for an alternative monetary framework that I call a temporary price-level target—temporary, because it would apply only at times when short-term interest rates are at or very near zero.
To explain my proposal, I’ll begin by briefly discussing two other ideas for changing the monetary framework: raising the Fed’s inflation target above the current 2 percent level, and instituting a price-level target that would operate at all times. (See my paper for more details.)
A Higher Inflation Target
One way to increase the scope for monetary policy is to retain the Fed’s current focus on hitting a targeted value of inflation, but to raise the target to, say, 3 or 4 percent. If credible, this change should lead to a corresponding increase in the average level of nominal interest rates, which in turn would give the Fed more space to cut rates in a downturn. This approach has the advantage of being straightforward, relatively easy to communicate and explain; and it would allow the Fed to stay within its established, inflation-targeting framework. However, the approach also has a number of notable shortcomings (as I have discussed here and here).
One obvious problem is that a permanent increase in inflation would be highly unpopular with the public. The unpopularity of inflation may be due to reasons that economists find unpersuasive, such as the tendency of people to focus on inflation’s effects on the prices of things they buy but not on the things they sell, including their own labor. But there are also real (if hard to quantify) problems associated with higher inflation, such as the greater difficulty of long-term economic planning or of interpreting price signals in markets. In any case, it’s not a coincidence that the promotion of price stability is a key part of the mandate of the Fed and most other central banks. A higher inflation target would therefore invite a political backlash, perhaps even a legal challenge.
More subtle, but equally important, we know from the insightful theoretical work of Paul Krugman, Michael Woodford and Gauti Eggertsson, and others that raising the inflation target is an inefficient approach to dealing with the ZLB. Under the theoretically optimal approach, inflation should rise temporarily following a severe downturn in which monetary policy is constrained by the ZLB. The reason for the temporary increase is that, in the optimal framework, policymakers promise to hold rates “lower for longer” when the ZLB is binding, in order to make up for the fact that the ZLB is preventing current short-term rates from falling as far as would be ideal. The promise of “lower for longer,” if credible, should ease financial conditions before and during the ZLB period, reducing the adverse effects on output and employment but subsequently resulting in a temporary increase in inflation. As Woodford has pointed out (pp. 64-73), raising the inflation target is a suboptimal response to the ZLB problem in that it forces society to bear the costs of higher inflation at all times, instead of only transitorily after periods at the ZLB. Moreover, a once-and-for-all increase in the inflation target does not take into account that, under the theoretically optimal policy, the vigor of the policy response (and thus the magnitude of the temporary increase in inflation) should be calibrated to the duration of the ZLB episode and the severity of the economic downturn.
An alternative monetary framework, discussed favorably by President Williams and by a number of others (see here and here) is price-level targeting. A price-level-targeting central bank tries to keep the level of prices on a steady growth path, rising by (say) 2 percent per year; in other words, a price-level-targeter tries to keep the very-long-run average inflation rate at 2 percent.
The principal difference between price-level targeting and conventional inflation targeting is the treatment of “bygones.” An inflation-targeter can “look through” a temporary change in the inflation rate so long as inflation returns to target after a time. By ignoring past misses of the target, an inflation targeter lets “bygones be bygones.” A price-level targeter, by contrast, commits to reversing temporary deviations of inflation from target, by following a temporary surge in inflation with a period of inflation below target; and an episode of low inflation with a period of inflation above target. Both inflation targeters and price-level targeters can be “flexible,” in that they can take output and employment considerations into account in determining the speed at which they return to the inflation or price-level target. Throughout this post I am considering only “flexible” variants of policy frameworks. These variants are both closer to the optimal strategies derived in economic models and most consistent with the Fed’s dual mandate, which instructs it to pursue maximum employment as well as price stability.
A price-level target has at least two advantages over raising the inflation target. The first is that price-level targeting is consistent with low average inflation (say, 2 percent) over time and thus with the price stability mandate. The second advantage is that price-level targeting has the desirable “lower for longer” or “make-up” feature of the theoretically optimal monetary policy. Under price-level targeting, there is automatic compensation by policymakers for periods in which the ZLB prevents monetary policy from providing adequate stimulus. Specifically, periods in which inflation is below target (as is likely to happen when interest rates are stuck at the ZLB) must be followed by periods in which the central bank shoots for inflation above target, with the overshoot depending (as it optimally should) on the severity of the episode and the cumulative shortfall in monetary easing. If the public understands and expects the central bank to follow the “lower-for-longer” rate-setting strategy, then the expectation of easier policy and more-rapid growth in the future should mitigate declines in output and inflation during the period in which the ZLB is binding, and indeed reduce the frequency with which the ZLB binds at all.
For these reasons, adopting a price-level target seems preferable to raising the inflation target. However, this strategy is not without its own drawbacks. For one, it would amount to a significant change in the Fed’s policy framework and reaction function, and it is hard to judge how difficult it would be to get the public and markets to understand the new approach. In particular, switching from the inflation concept to the price-level concept might require considerable education and explanation by policymakers. Another drawback is that the “bygones are not bygones” aspect of this approach is a two-edged sword. Under price-level targeting, the central bank cannot “look through” supply shocks that temporarily drive up inflation, but must commit to tightening to reverse the effects of the shock on the price level. Given that such a process could be painful and have adverse effects on employment and output, the Fed’s commitment to this policy might not be fully credible.
Temporary Price-Level Targeting
Is there a compromise approach? One possibility is to apply a price-level target and the associated “lower-for-longer” principle only to periods around ZLB episodes, retaining the inflation-targeting framework and the current 2 percent target at other times. As with the ordinary price-level target, this approach would implement the lower-for-longer or “make-up” strategy at the ZLB, which—if understood and anticipated by the public—should serve to make encounters with the ZLB shorter, less severe, and less frequent. In this respect, a temporary price-level target would be similar to an ordinary price-level target, which applies at all times. However, a temporary price-level target has two potential advantages.
First, a temporary price-level target would not require a major shift away from the existing policy framework: When interest rates are away from the ZLB, the current inflation-targeting framework would remain in place. And at the ZLB, what I am calling here temporary price-level targeting could be explained and communicated as part of an overall inflation-targeting strategy, as it amounts to targeting the average inflation rate over the period in which the ZLB is binding. Thus, communication could remain entirely in terms of inflation goals, a concept with which the public and market participants are already familiar.
Second, a temporary price-level target, unlike an ordinary price-level target, would not require the Fed to tighten policy to reverse shocks that temporarily drive up inflation when rates are away from the ZLB. Instead, following the inflation-targeter’s approach, the Fed would simply guide inflation back to target over time. Moreover, because the Fed would be targeting 2 percent inflation in both ZLB and non-ZLB periods, inflation over long periods should average around 2 percent.
To be more concrete on how the temporary price-level target would be communicated, suppose that, at some moment when the economy is away from the ZLB, the Fed were to make an announcement something like the following:
The Federal Open Market Committee (FOMC) has determined that it will retain its symmetric inflation target of 2 percent. The FOMC will also continue to pursue its balanced approach to price stability and maximum employment. In particular, the speed at which the FOMC aims to return inflation to target will depend on the state of the labor market and the outlook for the economy.
However, the FOMC recognizes that, at times, the zero lower bound on the federal funds rate may prevent it from reaching its inflation and employment goals, even with the use of unconventional monetary tools. The Committee therefore agrees that, in future situations in which the funds rate is at or near zero, a necessary condition for raising the funds rate will be that average inflation since the date at which the federal funds rate first hit zero be at least 2 percent. Beyond this necessary condition, in deciding whether to raise the funds rate from zero, the Committee will consider the outlook for the labor market and whether the return of inflation to target appears sustainable.
The charts below serve to illustrate this policy as might have been applied to the most recent ZLB episode if, hypothetically, temporary price-level targeting had been in effect. To be clear, nothing in this blog post or my paper should be taken as a commentary on current Fed policy. I am considering instead a counterfactual world in which the announcement above had been made, and internalized by markets, prior to when the short-term rate hit zero in 2008.
Figure 1 shows the behavior of (core PCE) inflation since 2008 Q4, the quarter in which the federal funds rate effectively reached zero and thus marked the beginning of the ZLB episode. Since 2008, inflation has been below the 2 percent inflation target most of the time.
The effect of this persistent undershoot of inflation relative to the 2 percent target has been a persistent undershoot of the overall level of prices, relative to trend. Figure 2 shows recent values of the (core PCE) price level relative to a 2 percent trend starting in 2008 Q4. As the figure shows, the price level is lower than it would have been had inflation been at the Fed’s 2% inflation target over the entire period.
If a temporary price-level target had been in place, the Fed would have sought to “make up” for this cumulative shortfall in inflation. The necessary condition outlined in paragraph (2) of the framework, that average inflation over the ZLB period be at least 2 percent, is equivalent to the price level (light blue line) returning to its trend (dark blue line). A period of inflation exceeding 2 percent would be necessary to satisfy that criterion, thereby compensating for the previous shortfall in inflation during the ZLB period (i.e. the slope of the light blue line would need to increase in order to converge with the dark blue line). The result would be a lower-for-longer rates policy, which would be communicated and internalized by markets in advance. The easier financial conditions that would have resulted could have hastened the desired outcomes of economic recovery and the return of inflation to target. Notably, this framework would obviate the need for (and be superior to) the use of ad hoc forward guidance about rate policy.
Importantly, under my proposal and as suggested by the mock FOMC statement above, meeting the average-inflation criterion is a necessary but not sufficient condition to raise rates from the ZLB. First, monetary policymakers would want to be sure that the average inflation condition is being met on a sustainable basis and not as the result of a transitory shock or measurement error. Expressing the condition in terms of core rather than headline inflation, as in the figures above, would help on that score. Second, consistent with the concept of “flexible” targeting, policymakers would also want to factor in real economic conditions such as employment and output in deciding whether it was time to raise rates.
In sum, a temporary price-level target, invoked only during ZLB episodes, appears to have many of the benefits of ordinary price-level targeting. It would preserve the commitment to price stability. Importantly, it would create the expectation among market participants that ZLB episodes will lead to “lower-for-longer” or “make-up” rate policies, which would ease financial conditions and help mitigate the frequency and severity of such episodes. Unlike an ordinary price-level target, however, the temporary variant could be folded into existing inflation-targeting regimes in a straightforward way, minimizing the need to change longstanding policy frameworks and communications practices. In particular, central bank communication could remain focused on inflation goals. Finally, in contrast to an ordinary price-level target, the proposed approach would allow policymakers to continue to “look through” temporary inflation shocks that occur when rates are away from the ZLB.
 This problem would be mitigated but not eliminated if the price-level target were defined in terms of core inflation, excluding volatile food and energy prices.
Over the years, I’ve done a lot thinking and writing about challenges faced by Japanese monetary policymakers in their attempts to combat deflation. In some of my earlier pieces I argued that, if the Bank of Japan (BOJ) showed more resolve, it could readily overcome these problems. But, in recent years, the Bank has shown great resolve, and while the results have generally been positive, deflation has not been decisively vanquished. In particular, the BOJ has had difficulty meeting its goal of getting inflation sustainably to 2 percent per year.
In a May 24 lecture at the Bank of Japan, I reviewed my past advice to see how it has stood the test of time, and I offered some thoughts on what options the BOJ might consider if its current policy framework is insufficient to achieves its inflation objectives.
Some of my key conclusions are as follows:
The BOJ shouldn’t stop its determined pursuit of its inflation target even though the economy is currently performing well by some measures. Among other reasons, getting inflation and interest rates higher will promote economic stability by increasing the BOJ’s ability to respond to future recessions.
Monetary policy in Japan became much more aggressive in 2013, following the election of Shinzo Abe and his appointment of Haruhiko Kuroda as governor of the BOJ. Kuroda’s program of “qualitative and quantitative easing” has had important benefits, including higher inflation and nominal GDP growth and tighter labor markets. Recent changes to the BOJ’s framework will make it more sustainable. However, some features of the Japanese economy and the legacies of past policies are interacting to prevent faster progress towards the BOJ’s inflation objective. Whether the objective will be met over the next few years remains to be seen and depends in part on factors outside the central bank’s control.
What tools remain if current policies are not enough? The scope for significant further easing by Japanese monetary authorities on their own seems limited, as interest rates are near zero for government bonds even at long maturities and raising inflation expectations—a way to lower real interest rates—has proved difficult. If more stimulus is needed, the most promising direction would be through fiscal and monetary cooperation, in which the BOJ agrees to temporarily raise its inflation target as needed to offset the effects of new fiscal spending or tax cuts on the debt-to-GDP ratio. Such coordination could help generate the extra aggregate demand the BOJ is seeking, without worsening Japan’s fiscal situation or compromising central bank independence.
Importantly, though, KR’s simulations assume that the Fed continues to employ monetary policies similar to those used before the crisis, as described by some simple policy rules. That’s unrealistic, as in recent years the Fed has demonstrated that it will deviate from the standard playbook when rates are near zero. Indeed, as I discussed in yesterday’s post, markets and professional economic forecasters seem confident that the Fed will be able to mitigate the effects of future encounters with the zero lower bound (ZLB), in that they see inflation remaining close to the Fed’s 2 percent target in the long run.
The confidence of market participants and forecasters in the central bank is encouraging, but it only ups the ante: To be able to meet those expectations, the Fed should plan now for future encounters with the ZLB. In this post I’ll discuss the pros and cons of one leading proposal, which is for the Fed to increase its official inflation target. The case for that step, I’ll argue, is mixed at best. Drawing on Kiley and Roberts’ research, I’ll then consider some alternatives that I believe show more promise.
Responding to the ZLB constraint: the case for raising the Fed’s inflation target
The risk of hitting the zero lower bound depends importantly on the “normal” level of interest rates, that is, the level of rates expected to prevail when the economy is operating at full employment with price stability and monetary policy is at a neutral setting. What determines the normal rate? In general, any interest rate can be expressed as the sum of a real, or inflation-adjusted, rate and the expected rate of inflation. Current estimates of the real interest rate likely to prevail during normal times cluster around 1 percent, well down from the recent past. Together with the Fed’s commitment to keep inflation close to 2 percent in the longer term, a 1 percent real rate implies that the average level of (nominal) interest rates in the future should be around 3 percent. As KR show via their simulations, this low level greatly increases the risk that, all else equal, monetary policy will be constrained by the zero lower bound. That is, in a persistently low-rate world we could frequently see situations in which the Fed would like to cut its policy rate but will be unable to do so. The result could be subpar economic performance.
One potential solution to this problem, suggested by leading economists like Olivier Blanchard, is for the Fed to raise its inflation target. Suppose for example that the Fed were to set its target inflation rate at 3 percent, and that the normal real interest rate remained at 1 percent. If markets were confident that the Fed would maintain and consistently hit that target, then the normal level of interest rates should also rise—in this example, from 3 percent to 4 percent—increasing the scope for rate cuts during periods of recession or low inflation.
I’d add another important advantage of this approach, which is that an increase in the Fed’s inflation target is a relatively simple step that would be easy to communicate to the public. In particular, the Fed’s policy framework, which is already focused on targeting the inflation rate, would not have to change.
Some arguments against raising the inflation target
There are, however, some reasons that raising the Fed’s inflation target might not be such a good idea.
First, much of the recent discussion of the optimal choice of inflation target feels ahistorical, in that it debates what the ideal inflation target would be if 1) we were somehow starting from scratch and 2) we were certain that present conditions would persist indefinitely. Of course, we are not starting with a blank slate: It took years of demonstrated success for the Fed and other central banks to firmly anchor the public’s inflation expectations at current levels, which in turn has helped stabilize inflation and improved policy outcomes. It might be difficult and costly to re-anchor inflation expectations, and thus normal interest rates, at a higher level, especially as, in taking this step, the Fed would have demonstrated that it was willing to shift the target for what would appear to be tactical reasons.
Looking forward, it is likely that the determinants of the “optimal” inflation target—such as the prevailing real interest rate, the costs of inflation, and the nature of the monetary policy transmission mechanism—will change over time. If the Fed raised its inflation target today based primarily on the low level of real interest rates, would it change the target again in response to future changes in fundamentals? That would be important to clarify when the first change was made. The broader point here is that, in a changing world of imperfect credibility and incomplete information, private-sector inflation expectations are not so easy to manage. In particular, the cost-benefit calculus of a target change should incorporate transition costs, including the risks of triggering market instability and economic uncertainty.
Second, although quantifying the economic costs of inflation has proved difficult and controversial, we know that inflation is very unpopular with the public. This may be due to reasons that economists find unpersuasive—e.g., people may believe that the wage increases they receive are fully earned (that is, not due in part to prevailing inflation), while simultaneously blaming inflation for eroding the purchasing power of those wages.  Or perhaps the public perceives costs of inflation—the greater difficulty of calculation and planning when inflation is high, for example—that economists have difficulty quantifying. Whether the public’s antipathy toward inflation is justified in some sense or not, the politics of raising the inflation target (and of sustaining higher inflation) would be very tricky, which in turn would reduce the credibility of such an announcement by the Fed. If the increase in the target is not credible, normal interest rates will not rise, which is the goal of the exercise. From a political perspective, it seems that, for Fed leadership, raising the inflation target is dominated by a strategy of pushing for greater fiscal activism at the zero lower bound, which in any case is the approach preferred by most economists as more likely to be effective.
Third, theoretical analyses suggest that raising the inflation target is in any case not the optimal policy response to worries about the ZLB. As is now well understood, the theoretically preferred response (see here and here for classic statements) is for the Fed to promise in advance to follow a “make-up” policy: That is, if the presence of the ZLB keeps policy tighter than it otherwise would be for a time, the Fed should compensate by keeping rates lower for longer after the ZLB stops binding, where the length of the “make-up” period is greater following more severe ZLB episodes. If (an important “if”) this promise is understood and believed by market participants and the public, then the expectation of easier policy in the future should act to mitigate declines in output and inflation during the period in which the ZLB is binding.
From this perspective, raising the inflation target is an inefficient policy in two respects. First, as Michael Woodford has pointed out, it forces society to bear the costs of higher inflation at all times, whereas under the optimal policy inflation rises only temporarily following ZLB episodes. Second, a one-time increase in the inflation target does not optimally calibrate the vigor of the policy response to a given ZLB episode to the duration or severity of that episode. KR’s simulations confirm that raising the inflation target does allow the Fed to respond more effectively to recessions than is possible under their baseline, pre-crisis policies. But they also find that raising the inflation target does not improve performance as much as some alternative strategies (see below), even ignoring the costs of a permanent increase in inflation associated with a higher target.
Are there better responses to the ZLB than raising the inflation target?
If the Fed sees raising the inflation target as unattractive, what else can it do to reduce the frequency and severity of future ZLB episodes? One possibility, which seems desirable in any case, is just to build on and improve the approaches used between 2008 and 2015. Strategies the Fed used to address the zero lower bound included aggressive rate-cutting early on, quantitative easing, forward guidance about future rate paths, and a “risk-management” strategy that entails a very cautious liftoff from the zero bound when the time comes. As I noted earlier, Fed officials and economists generally could also press for more active use of fiscal policy in serious downturns. This more-incremental approach has the advantage of not requiring sharp changes in the Fed’s existing policy framework, and some research suggests that it could handle at least moderate downturns, even without support from fiscal policy. However, it’s not clear that this more-conservative approach would be sufficient in the face of a very sharp recession that forced rates down to the ZLB for a protracted period.
If the Fed wanted to go farther, it could consider changing what it targets from inflation to some other economic variable. There have been many proposals, each with its own strengths and weaknesses. One possibility that has some attractive features is a so-called price-level target. With a price-level target the Fed would commit to making up misses of its desired inflation level. For example, if inflation fell below 2 percent for a time the Fed would compensate by aiming for inflation above 2 percent until average inflation over the whole period had returned to 2 percent. The adoption of price-level targeting would be preferable to raising the inflation target, as price-level targeting is both more consistent with the Fed’s mandate to promote price stability and because it is more similar to an optimal “make-up” monetary policy. (Following a ZLB episode, a price-level-targeting central bank would be committed to making up any shortfall of inflation.)
Price-level targeting does have drawbacks as well. For example, if a rise in oil prices or another supply shock temporarily increases inflation, a price-level-targeting central bank would be forced to tighten monetary policy to push down subsequent inflation rates, even if the economy were in a downturn. In contrast, an inflation-targeting central bank could “look through” a temporary inflation increase, letting inflation bygones be bygones.
Another alternative would be to try to implement the optimal “make-up” strategy, in which the Fed commits to compensating for the effects of the ZLB by holding rates low for a time after the ZLB no longer binds, with the length of the make-up period explicitly depending on the severity of the ZLB episode. KR consider several policies of this type and show in their simulations that such policies reduce the frequency of ZLB episodes and largely eliminate their costs, while keeping average inflation close to 2 percent. The main challenges for this approach are in communicating it clearly and ensuring that it is credible, since if market participants and the public don’t believe that the central bank will carry through on its promise to keep rates low, the policy won’t work. However, the Fed’s recent experience with forward guidance suggests that such commitments by central banks can be effective.  They would probably be even more effective if the principles of this approach were laid out and explained in a normal period in which the ZLB was not binding.
As price-level targeting and “make-up” policies are closely related, they could be combined in various ways. For example, by promising to return the price level to trend after a period at the zero lower bound, the Fed could use the language of price-level targeting to make precise its commitment to make up for its inability to respond adequately during the period when rates are at zero.
As Kiley and Roberts’s research confirms, the Fed and other central banks cannot ignore the risks created by a low level of “normal” interest rates, which in turn limit the scope for interest-rate cuts. A wide-ranging discussion of alternative policy approaches would thus be welcome. Although raising the inflation target is one of the options that should be considered, that approach has significant drawbacks. Fortunately, there are promising policy options that may be able to mitigate the effects of the zero lower bound on interest rates without forcing the public to accept a permanently higher rate of inflation. Two such options (which are related, and could be combined) are price-level targeting and a “make-up” approach, under which the central bank commits to compensating for “missing” monetary ease after the economy leaves the zero lower bound.
 As I discussed yesterday, people’s ability to switch to cash, which pays zero interest, limits how far interest rates can fall. In practice, because there are costs to holding cash (e.g., storage and security), interest rates can go slightly negative, as we’ve seen in Europe and Japan. For simplicity, and because the Fed has never used negative interest rates, in this post I’ll refer to the zero lower bound on rates.
 Economists use the term “money illusion” to refer to various confusions between real (inflation-adjusted) and unadjusted values. But even illusions have real costs, if they lead to mistaken decisions.
 For an interesting discussion of the importance of the “make-up” principle in the context of European Central Bank policy, see this speech by ECB chief economist Peter Praet.
Comments are welcome, but because of the volume, we only post selected comments.
If inflation is too low or unemployment too high, the Fed normally responds by pushing down short-term interest rates to boost spending. However, the scope for rate cuts is limited by the fact that interest rates cannot fall (much) below zero, as people always have the option of holding cash, which pays zero interest, rather than negative-yielding assets.  When short-term interest rates reach zero, further monetary easing becomes difficult and may require unconventional monetary policy, such as large-scale asset purchases (quantitative easing).
Before 2008, most economists viewed this zero lower bound (ZLB) on short-term interest rates as unlikely to be relevant very often and thus not a serious constraint on monetary policy. (Japan had been dealing with the ZLB for several decades but was seen as a special case.) However, in 2008 the Fed responded to the worsening economic crisis by cutting its policy rate nearly to zero, where it remained until late 2015. Although the Fed was able to further ease monetary policy after 2008 through unconventional methods, the ZLB constraint greatly complicated the Fed’s task.
In this post I discuss the KR result but also point out a puzzle. If in the future the ZLB will often prevent the Fed from providing sufficient stimulus, then, on average, inflation should be expected to fall short of the Fed’s 2 percent target—a point shown clearly by KR’s simulations. The puzzle is that neither market participants nor professional forecasters appear to expect such an inflation shortfall. Why not? There are various possibilities, but it could be that markets and forecasters simply have confidence that the Fed will develop policy approaches to overcome the ZLB problem. It will be up to the Fed to prove worthy of that confidence.
The frequency and severity of ZLB episodes
As I’ve noted, KR’s research suggests that periods during which the short-term interest rate is at or close to zero may be frequent in the future. They also find that these episodes would typically last several years on average and (because monetary policy is hobbled during such periods) result in poor economic performance. Two key assumptions underlie these conclusions.
First is the presumption that the current, historically low level of interest rates will persist, even when the economy is once again operating at normal levels and monetary policy has returned to a more-neutral setting. As another paper at the Brookings conference examined in some detail, real (inflation-adjusted) interest rates have been declining for decades, for reasons including slower economic growth; an excess of global savings relative to attractive investment opportunities; an increased demand for safe, liquid assets; and other factors largely out of the control of monetary policy. If the normal real interest rate is currently about 1 percent—a reasonable guess—and if inflation is expected on average to be close to the Fed’s target of 2 percent, then the nominal interest rate will be around 3 percent when the economy is at full employment with price stability. Naturally, if interest rates are typically about 3 percent, then the Fed has much less room to cut than when rates are 6 percent or more, as they were during much of the 1990s, for example. Indeed, the KR simulations show that the expected frequency of ZLB episodes rises quite sharply when normal interest rates fall from 5 or 6 percent to 3 percent.
The second factor determining the frequency and severity of ZLB episodes in the KR simulations is the Fed’s choice of monetary policies. This important point is worth repeating: The frequency and severity of ZLB episodes is not given, but depends on how the Fed manages monetary policy. In particular, KR’s baseline results assume that the Fed follows one of two simple policy rules: one estimated from the Fed’s past behavior, and the second determined by a standard Taylor rule, which relates the Fed’s short-term interest rate target to the deviation of inflation from the Fed’s 2 percent target and on how far the economy is from full employment. Using the Fed’s principal forecasting model, KR find that in the future the U.S. economy will be at the ZLB 32 percent of the time under the estimated monetary policy rule, and 38 percent of the time under the Taylor-rule policy. Because of the frequent encounters with the ZLB, the simulated economic outcomes are not very good: Under either policy rule, on average inflation is about 1.2 percent (well below the Fed’s 2 percent target) and output is more than 1 percent below its potential.
What do markets and professional forecasters think?
Are these results plausible? A specific prediction of the KR analysis, that in the future frequent contact with the ZLB will keep inflation well below the Fed’s 2 percent target, can be compared to the expectations of market participants and of professional forecasters.
These comparisons do not generally support KR’s worst-case scenarios. For example, measures of inflation expectations based on comparing returns to inflation-adjusted and ordinary Treasury securities, suggest that market participants see inflation remaining close to the Fed’s 2 percent target in the long run. The prices of derivatives that depend on long-run inflation outcomes also imply that market expectations of inflation are close to 2 percent. To illustrate the latter point, Figure 1 shows inflation expectations as derived from zero-coupon inflation swaps. (See here for an explanation of these instruments and a discussion of their properties.)
Figure 1 suggests that market participants expect inflation to average about 2-1/4 percent over long horizons, up to thirty years. These expectations relate to inflation as measured by the consumer price index, which tends to be a bit higher than inflation measured by the index for personal consumption expenditures, the inflation rate targeted by the Fed. So Figure 1 seems quite consistent with a market expectation of 2 percent for the Fed’s targeted inflation rate over very long horizons.
That longer-term inflation expectations appear relatively well-anchored at 2 percent appears inconsistent with the prediction that interest rates will be at the ZLB as much as 30 to 40 percent of the time in the future, preventing the Fed from reaching its inflation target during those times.
How to resolve this contradiction? I don’t think there’s anything wrong with how KR conducted their analyses. Remember, though, their conclusion assumes that the Fed will continue to manage monetary policy using pre-crisis approaches, essentially ignoring the challenges of the zero lower bound. That’s unrealistic. Indeed, following the crisis the Fed addressed the ZLB constraint with a number of alternative strategies, including large-scale asset purchases (quantitative easing) and forward guidance to markets about the future path of interest rates. These policy innovations did not fully overcome the ZLB problem. Nevertheless, they may help explain why the unemployment rate and other measures of cyclical slack fell about as quickly in the recent recovery as in earlier postwar recoveries—a finding of another paper at the Brookings conference, by Fernald, Hall, Stock, and Watson—and also why core PCE inflation fell by less than expected given the severity of the recession.
Looking forward, it appears that market participants and professional forecasters believe that the Fed, perhaps in conjunction with fiscal policymakers, will “do what it takes” to mitigate the adverse effects of future encounters with the ZLB. That confidence is encouraging, but it should not be taken as license for policymakers to rest on their laurels. To the contrary, Fed and fiscal policymakers should think carefully about how best to adapt their frameworks and policy tools to reduce the frequency and severity of future ZLB episodes. In tomorrow’s post I’ll discuss some possible approaches.
 A logical possibility is that market participants and forecasters expect the Fed to shoot for inflation above 2 percent during periods when the ZLB is not binding, in order to achieve an overall average of 2 percent inflation. KR analyze this possibility in simulations. However, although Fed policymakers may be willing to allow inflation to exceed the 2 percent target modestly and temporarily, consistent with the symmetry of the inflation target, they have given no indication that they will tolerate a sustained overshoot.
 Since holding cash involves costs of its own, interest rates can in fact go slightly negative, as we’ve seen in Japan and Europe. For this reason, the literature generally refers to the effective lower bound on interest rates (which in practice appears to be somewhere between minus one-half and minus one percent) rather than the traditional term zero lower bound. Since this post focuses on the Fed, which has not employed negative interest rates, I’ll refer here to the zero lower bound.
 The inflation breakevens for ten-year, thirty-year, and five-year five-year-forward horizons are currently all about 2 percent. From 2009 through 2014, these breakevens remained above 2 percent, at levels comparable to the period before the crisis. Breakevens fell below 2 percent in 2015-2016, but most commentary attributes that drop to declines in inflation risk premiums rather than lower inflation expectations; see here for a discussion.
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