Academic journal article Brookings Papers on Economic Activity

Comment by Ben Bernanke

Academic journal article Brookings Papers on Economic Activity

Comment by Ben Bernanke

Article excerpt

Over the years, the Brookings Papers on Economic Activity has published a remarkably large share of the most important papers on the conduct of monetary policy when interest rates are near their zero lower bound--or, more accurately, at their "effective" lower bound (ELB), because central banks have been able to set short-term rates at modestly negative levels. The seminal papers by Paul Krugman (1998) and Gauti Eggertsson and Michael Woodford (2003) appeared in the Brookings Papers, as did papers on the zero lower bound by Ben Bemanke, Vincent Reinhart, and Brian Sack (2004); John Williams (2009); Jeffrey Campbell and others (2012); and Charles Evans and others (2015). And that does not include the closely related work of Joshua Hausman and Johannes Wieland (2014, 2015) on Japanese monetary policy, and Marco Del Negro and others (2017) on why the natural rate of interest appears to be so low.

Building on this tradition, this paper by Michael Kiley and John Roberts is a useful update and extension of the ELB literature. It is also timely: With the Federal Reserve apparently on a trajectory to escape the gravitational pull of the ELB, a serious discussion of whether and how the monetary pohcy framework should be modified to better deal with the ELB constraint in the future is certainly warranted.

My discussion is in three sections. I first comment on Kiley and Roberts's quantitative assessment of the frequency, duration, and severity of ELB episodes (by which I mean periods when the policy interest rate is at or very close to its ELB). Second, I discuss the paper's findings about the optimal response of monetary policymakers to the ELB constraint. Finally, I briefly turn to what I believe to be a serious, if understandable, shortcoming of both this paper and much of the literature, namely, paying insufficient attention to the communication challenges that central banks face when interest rates are close to the ELB.

On the first point, Kiley and Roberts emphasize their finding, based on model simulations, that ELB episodes are likely to be more frequent, longer, and more severe than previously believed. (They overstate a bit the extent to which earlier research downplayed the ELB threat, I think, but it is true that some earlier papers characterized the risks associated with the ELB as likely to be manageable, at least in the U.S. context.) Although, in principle, many factors could influence the frequency and severity of ELB episodes, for Kiley and Roberts the most important reason for increased concern about the ELB is the secular decline in the equilibrium nominal interest rate, from about 6 percent in the precrisis era to about 3 percent today. Why interest rates have declined so much, and whether the decline is permanent, are contentious questions; Del Negro and others (2017) discuss the evidence in more detail. What is clear is that the lower the "normal" level of interest rates, the less space exists for the central bank to cut rates to mitigate an economic downturn.

Kiley and Roberts appropriately emphasize that the frequency and severity of ELB episodes are not exogenous features of the economic environment but instead are endogenous and jointly determined with the monetary (and fiscal) policy regimes. In other words, statements about the risks of the ELB must be conditional on the type of policy being assumed. In this context, Kiley and Roberts show that some "standard" monetary policy rules can lead to very poor results when the equilibrium nominal interest rate is 3 percent or lower. For example, they find that a rule estimated to mimic the Fed's historical behavior, when incorporated into simulations of the FRB/US model (the Fed's main policy model), implies that the economy will be at the ELB 32 percent of the time, that output will average 1.3 percent below potential, and that inflation will average only 1.2 percent (compared with an official inflation target of 2 percent). …

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