Monetary Policy in a Low Interest Rate World

Nominal interest rates may remain substantially below the averages of the last half century, because central banks’ inflation objectives lie below the average level of inflation, and estimates of the real interest rate that are likely to prevail over the long run fall notably short of the average real interest rate experienced during 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 world of low interest rates, using both a dynamic stochastic general equilibrium (DSGE) model and the Federal Reserve’s largescale econometric model, the FRB/US model. Four main conclusions emerge. First, monetary policy strategies based on traditional, simple 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 are estimated to be significantly higher than in previous studies. Second, a risk adjustment to a simple rule—whereby 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, whereby monetary accommodation is not removed until either inflation or economic activity overshoots its longrun objective, are very effective in both the DSGE and FRB/US models. And fourth, our simulation results suggest that the adverse effects on economic and price stability associated with the ELB may be substantial at inflation targets near 2 percent if the equilibrium real interest rate is low and monetary policy follows a traditional approach. Whether such adverse effects could justify a higher inflation target depends upon the degree to which monetary policy strategies that differ substantially from such traditional approaches are feasible, and an assessment of a broader array of the inflation target’s effects on economic welfare.