Central Banking after the Great Recession: Lessons Learned, Challenges Ahead

3. Monetary Policy When Rates Hit Zero: Putting Theory into Practice

3 Monetary Policy When Rates Hit Zero Putting Theory into Practice John C. Williams 21 It has been said, “An economist is a man who, when he finds something works in practice, wonders if it works in theory.”1 The study of the zero lower bound (ZLB) on nominal interest rates is an example of precisely the opposite: economists first figuring out what works in theory and then seeing if it works in practice. Japan’s experience with price deflation and zero short-term interest rates beginning in the 1990s led to a flurry of economic research on the ZLB and its implications for monetary policy (see, for example, Benhabib, Schmitt-Grohé, and Uribe 2001; Eggertsson and Woodford 2003; Reifschneider and Williams 2000; and references therein). This research came to a number of concrete conclusions and policy prescriptions that influenced policymaking during and after the global financial crisis. The opinions expressed in this paper are those of the author and do not necessarily reflect the views of any other individuals within the Federal Reserve System. I thank Early Elias and Kuni Natsuki for excellent research assistance, and Eric Swanson for assistance in compiling research results. 1. This quotation is often attributed to the economist Walter Heller. 03-2608-1 ch3.indd 21 3/11/14 9:56 PM 22 JOHN C. WILLIAMS One conclusion from the precrisis research was that the ZLB was a problem that could potentially afflict any economy with a sufficiently low inflation target, but that the episodes at the ZLB would be relatively infrequent and generally short-lived. For example, Reifschneider and Williams (2000) found that under a standard Taylor (1993) monetary policy rule and a 2 percent inflation target, monetary policy would be constrained at the ZLB about 5 percent of the time, and ZLB episodes would typically last just one year. Other research came to even more sanguine conclusions regarding the likely effects of the ZLB, in part because that research was often predicated on an economic environment similar to the tranquil Great Moderation period of the 1980s and 1990s in the United States (see, for example, Adam and Billi 2006; Coenen, Orphanides, and Wieland 2004; Schmitt-Grohé and Uribe 2007). Second, this research identified monetary policy strategies that should be effective at reducing most of the adverse effects of the ZLB. Specifically , short-term rates should be cut aggressively when deflation or a severe downturn threatens (Reifschneider and Williams 2000, 2002). That is, do not “keep your powder dry.” In addition, short-term rates should be kept “lower for longer” as the economy recovers (Eggertson and Woodford 2003; Reifschneider and Williams 2000, 2002). In theory , the expectation of a sustained low level of short-term interest rates reduces longer-term yields and eases financial conditions more broadly. In these two ways, the maximal amount of monetary stimulus can be put into place quickly. Indeed, this research found that such strategies should, in most cases, be sufficient to nearly fully offset the effects of the ZLB on the economy. Third, some researchers argued that unconventional policy actions such as central bank large-scale asset purchases (LSAP) of longer-term securities or foreign exchange can complement conventional policy actions by making financial conditions more favorable for growth even when short rates are constrained by the ZLB (Bernanke and Reinhart 2004; Bernanke, Reinhart, and Sack 2004; McCallum 2000; Svensson 2001). Of course, within a few years of the publication of this research, the ZLB went from being a theoretical concern to a very real practical problem for many central banks across the globe. Figure 3-1 shows the policy rates for four major advanced economies since 1990. The Bank of England , the Bank of Japan, the European Central Bank, and the Federal 03-2608-1 ch3.indd 22 3/11/14 9:56 PM Monetary Policy When Rates Hit Zero 23 Reserve all brought their policy rates to their respective effective lower bounds in late 2008 or early 2009. Central banks quickly sought to put into practice many of the prescriptions that researchers had identified. The experiences of the past six years provide a wealth of data on what works and what doesn’t, which theories have proved useful, and which need to be reconsidered. This essay reexamines the three key issues just outlined, all highlighted in research related to the ZLB, and lays out three still unanswered questions for monetary policy in a...