BPEA | Spring 2017

Monetary policy in a low interest rate world

Michael T. Kiley and
Michael T. Kiley Deputy Director, Financial Stability Program - Board of Governors of the Federal Reserve System
John M. Roberts
John M. Roberts Economist - Federal Reserve Board

March 23, 2017

Nominal interest rates may remain substantially below the averages of the last half-century, as central bank’s inflation objectives lie below the average level of inflation and estimates of the real interest rate likely to prevail over the long run fall notably short of the average real interest rate experienced over this period. Persistently low nominal interest rates may lead to more frequent and costly episodes at the effective lower bound (ELB) on nominal interest rates. We revisit the frequency and potential costs of such episodes in a low interest-rate world in a dynamic-stochastic-general-equilibrium (DSGE) model and large-scale econometric model, the FRB/US model. A number of conclusions emerge. First, monetary policy strategies based on traditional simple policy rules lead to poor economic performance when the equilibrium real interest rate is low, with economic activity and inflation more volatile and systematically falling short of desirable levels. Moreover, the frequency and length of ELB episodes under such policy approaches is estimated to be significantly higher than in previous studies. Second, a risk-adjustment to a simple rule in which monetary policymakers are more accommodative, on average, than prescribed by the rule ensures that inflation averages its 2 percent objective – and requires that policymakers systematically seek inflation near 3 percent when the ELB is not binding. Third, commitment strategies in which monetary accommodation is not removed until either inflation or economic activity overshoot their long-run objectives are very effective in both the DSGE and FRB/US model. Finally, raising the inflation target above 2 percent can mitigate the deterioration in economic performance; the desirability of such an approach ultimately hinges on the economic costs of inflation averaging more than 2 percent and assessments of the feasibility of commitment strategies.

Traders work on the floor of the New York Stock Exchange (NYSE) as a television screen shows news of the announcement that the U.S. Federal Reserve will hike interest rates in New York, U.S., December 14, 2016. REUTERS/Lucas Jackson - RTX2V201

In “Monetary policy in a low interest-rate world,” the Federal Reserve Board’s Michael T. Kiley and John M. Roberts, using standard economic models, find that rates could hit zero as much as 40 percent of the time—twice as often as predicted in work by others—according to standard economic models of the type used at the Federal Reserve and other central banks.

The constraint on monetary policy this would cause would make it harder for the Fed to achieve its 2 percent inflation objective and reach full employment. The authors’ analysis suggests that a monetary policy that tolerates inflation in good times near 3 percent, above its 2 percent long-run inflation target, may be necessary to bring inflation to 2 percent on average.

The natural rate of interest, a theoretical construct, is the interest rate that will prevail when the economy is at full employment and inflation is stable at a central bank’s target. When a central bank sets interest rates below that level, monetary policy is stimulating the economy; when the rate is above that level, it is doing the opposite. Most economists agree that the natural rate has been falling for decades. Fed policymakers’ projections indicate they see the long-run natural rate at 3 percent nominally, or about 1 percent after adjusting for inflation.

Given that the natural rate of interest has fallen and interest rates may not return to pre-crisis levels even after monetary policy has normalized, interest rates may be near zero much more often than in the decades prior to the crisis, with important consequences for the stability of inflation and economic activity. As a result, there are a number of steps the Federal Reserve and other central banks can take to help better achieve full employment and price stability in this low interest-rate environment.

This paper is part of the Spring 2017 edition of the Brookings Papers on Economic Activity, the leading conference series and journal in economics for timely, cutting-edge research about real-world policy issues. Research findings are presented in a clear and accessible style to maximize their impact on economic understanding and policymaking. The editors are Brookings Nonresident Senior Fellow and Northwestern University Economics Professor Janice Eberly and James Stock, Brookings Nonresident Senior Fellow and Harvard University economics professor. Read the rest of the articles here.

The authors did not receive financial support from any firm or person for this article or from any firm or person with a financial or political interest in this article. They are currently not an officer, director, or board member of any organization with an interest in this article.