Monetary Policy Alternatives at the Zero Bound: An Empirical Assessment

The conventional instrument of monetary policy in most major industrial economies is the very short term nominal interest rate, such as the overnight federal funds rate in the case of the United States. The use of this instrument, however, implies a potential problem: Because currency (which pays a nominal interest rate of zero) can be used as a store of value, the short-term nominal interest rate cannot be pushed below zero. Should the nominal rate hit zero, the real short-term interest rate—at that point equal to the negative of prevailing inflation expectations—may be higher than the rate needed to ensure stable prices and the full utilization of resources. Indeed, an unstable dynamic may result if the excessively high real rate leads to downward pressure on costs and prices that, in turn, raises the real short-term interest rate, which depresses activity and prices further, and so on.

Japan has suffered from the problems created by the zero lower bound (ZLB) on the nominal interest rate in recent years, and short-term rates in countries such as the United States and Switzerland have also come uncomfortably close to zero. As a consequence, the problems of conducting monetary policy when interest rates approach zero have elicited considerable attention from the economics profession. Some contributions have framed the problem in a formal general equilibrium setting; another strand of the literature identifies and discusses the policy options available to central banks when the zero bound is binding.¹

Although there have been quite a few theoretical analyses of alternative monetary policy strategies at the ZLB, systematic empirical evidence on the potential efficacy of alternative policies is scant. Knowing whether the proposed alternative strategies would work in practice is important to central bankers, not only because such knowledge would help guide policymaking in extremis, but also because the central bank's choice of its long-run inflation objective depends importantly on the perceived risks created by the ZLB. The greater the confidence of central bankers that tools exist to help the economy escape the ZLB, the less need there is to maintain an inflation "buffer," and hence the lower the inflation objective can be.²

This paper uses the methods of modern empirical finance to assess the potential effectiveness of so-called nonstandard monetary policies at the zero bound. We are interested particularly in whether such policies would work in modern industrial economies (as opposed to, for example, the same economies during the Depression era), and so our focus is on the recent experience of the United States and Japan.

The paper begins by noting that, although the recent improvement in the global economy and the receding of near-term deflation risks may have reduced the salience of the ZLB today, this constraint is likely to continue to trouble central bankers for the foreseeable future. Central banks in the industrial world have exhibited a strong commitment to keeping inflation low, but inflation can be difficult to predict. Although low inflation has many benefits, it also raises the risk that adverse shocks will drive interest rates to the ZLB.

Whether hitting the ZLB presents a minor annoyance or a major risk for monetary policy depends on the effectiveness of the policy alternatives available when prices are declining. Following a recent paper by two of the present authors,³ we group these policy alternatives into three classes: using communications policies to shape public expectations about the future course of interest rates; increasing the size of the central bank's balance sheet; and changing the composition of the central bank's balance sheet. We discuss how these policies might work, and we cite existing evidence on their utility from historical episodes and recent empirical research.

The paper's main contribution is to provide new empirical evidence on the possible effectiveness of these alternative policies. We employ two basic approaches. First, we use event-study methods to examine financial market responses to central bank statements and announcements. By using sufficiently narrow event windows, we can get precise estimates of...