Managing Monetary Policy at the Zero Interest Bound

 Introduction

The Federal Reserve’s near zero interest rate policy and $2 trillion dollar balance sheet have done much to stabilize economic and financial conditions in the United States. Yet the recovery from the Great Recession is slow. Net private job creation remains too low to absorb the secular growth in the labor force, let alone what is needed to return to work those who lost their jobs in the Great Recession.

Measures of underlying inflation have trended lower in recent quarters. Ongoing disinflation and the likelihood that labor markets will remain weak for some time suggest that inflation could fall further. The risk is that inflation expectations are dragged down, raising real interest rates and tightening interest rate policy. With five year market-based inflation expectations running near 1 ½ %, deflation does not yet present a clear and present danger.

Nevertheless, the market appears to be expecting the Fed in November to resume large-scale purchases of Treasury securities financed by bank reserve creation. The Fed has let speculation about its monetary policy actions overtake the presentation of the framework in which they are to be undertaken. Whether or not it acts in November, the Fed must provide the public with a coherent framework for understanding expansive monetary policy at the zero interest bound.

The Fed should prepare to preempt deflation as part of its longstanding program to promote price stability. The Fed can defeat deflation with monetary policy at the zero interest bound by expanding bank reserves well beyond $1 trillion, if need be. The operational imperative is this: The Fed must explain how an aggressive expansion of reserves could work against deflation without creating inflation, so that lenders don’t demand an inflation premium in long-term interest rates. The recovery from the Great Recession cannot continue unless the Fed stabilizes prices against both inflation and deflation.

The balance of the essay recommends a framework for managing monetary policy at the zero interest bound. The framework includes an explicit inflation objective, a bank reserves policy instrument, a description of the mechanics of broad liquidity, and cooperation from the fiscal authorities to enlarge the Fed’s surplus capital account to make the strategy against deflation fully credible.

Read the full report here.