Monetary Policy in a Low Interest Rate World

Abstract

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. Several conclusions emerge. First, monetary policy strategies based on traditional policy rules lead to poor economic performance when the equilibrium 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 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 achieves its 2 percent objective and requires that policymakers aim at 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, our results suggest that the adverse effects associated with the ELB may be substantial at inflation targets near 2 percent if r* is low and monetary policy follows a traditional policy approach. Whether such adverse effects could justify a higher inflation target depends on whether monetary policy strategies substantially different from traditional approaches are feasible and an assessment of the effects of the inflation target on economic welfare. ACKNOWLEDGMENTS

Quantitative Easing and the ‘New Normal’ in Monetary Policy

“…Kiley and Roberts () reconsider these issues, accounting for a lower equilibrium real interest rate and implementing computational improvements in imposing the ELB. They consider outcomes in a large‐scale econometric model, the FRB/US model of the Federal Reserve Board, and in the DSGE model of Lindé et al ().…”

“…The analysis uses the FRB/US model maintained by the Federal Reserve Board staff. This model is used to analyze the frequency and consequences of ELB episodes in Reifschneider and Williams (), Williams (), and Kiley and Roberts (); it provided the estimates of the effects of QE on the U.S. economy following 2008 in Chung et al () and Engen, Laubach, and Reifschneider, (); and Reifschneider () employed the FRB/US model to illustrate the ability of QE to address a recessionary shock starting from steady‐state conditions.…”

“…Much of our analysis will involve computation of moments from simulations of the FRB/US. In computing these simulations, I adopt an approach similar to that in Reifschneider and Williams (), Williams (), and Kiley and Roberts (). In particular, the simulations Generate 500 simulated samples of 200 periods (e.g., 40 years), initializing the simulations at the models’ non‐stochastic steady state.…”

“…Periods during which short‐term nominal interest rates are stuck at their effective lower bound (ELB) may be more frequent and costly in the future, as nominal interest rates may remain substantially below the norms of the last fifty years. Using simulations of a large‐scale econometric model and a dynamic‐stochastic‐general‐equilibrium (DSGE) model, Kiley and Roberts () estimate that the ELB may be encountered 40 per cent of the time or more under a rule for the short‐term interest rate of the type emphasized in Taylor () and Yellen ().…”

“…The analysis herein addresses this gap in the literature using a simulation approach—similar to that employed by Reifschneider and Williams (), Williams (), Coibion et al (), and Kiley and Roberts (). In this approach, a macroeconomic model is simulated many times, imposing the ELB, in order to assess implications of alternative strategies for the level and volatility of economic activity and inflation.…”