Monetary Policy when Short-Term Interest Rates are Near Zero
With the Fed's target interest rate falling, there's been some worry about running up against a "zero interest rate bound." This is from Federal Reserve Governor Frederic Mishkin's textbook on monetary economics:
3. Monetary policy can be highly effective in reviving a weak economy even if short-term interest rates are already near zero. We have recently entered a world where inflation is not always the norm. Japan, for example, recently experienced a period of deflation when the price level was actually falling. One common view is that when a central bank has driven down short-term nominal interest rates to near zero, there is nothing more that monetary policy can do to stimulate the economy The transmission mechanisms of monetary policy described here indicate that this view is false. As our discussion of the factors that affect the monetary base ... indicated, expansionary monetary policy to increase liquidity in the economy can be conducted with open market purchases, which do not have to be solely in short-term government securities. For example, purchases of foreign currencies, like purchases of government bonds, lead to an increase in the monetary base and in the money supply. This increased liquidity and a commitment to future expansionary monetary policy helps revive the economy by raising general price-level expectations and by reflating other asset prices, which then stimulate aggregate demand through the channels outlined here. Therefore, monetary policy can be a potent force for reviving economies that are undergoing deflation and have short-term interest rates near zero. Indeed, because of the lags inherent in fiscal policy and the political constraints on its use, expansionary monetary policy is the key policy action required to revive an economy experiencing deflation.
I don't think the lessons are exactly the same - e.g. we aren't having a problem with deflation and real interest rates appear to be low, not high, but this is interesting too:
Applying the Monetary Policy Lessons to Japan Until 1990, it looked as if Japan might overtake the United States in per capita income. Since then, the Japanese economy has been stagnating... Many economists take the view that Japanese monetary policy is in part to blame for the poor performance of the Japanese economy. Could applying the four lessons outlined in the previous section have helped Japanese monetary policy perform better?
The first lesson suggests that it is dangerous to think that declines in interest rates always mean that monetary policy has been easing. In the mid-1990s, when short-term interest rates began to decline, falling to near zero in the late 1990s and early 2000s, the monetary authorities in Japan took the view that monetary policy was sufficiently expansionary. Now it is widely recognized that this view was incorrect, because the falling and eventually negative inflation rates in Japan meant that real interest rates were actually quite high and that monetary policy was tight, not easy. If the monetary authorities in Japan had followed the advice of the first lesson, they might have pursued a more expansionary monetary policy, which would have helped boost the economy.
The second lesson suggests that monetary policymakers should pay attention to other asset prices in assessing the stance of monetary policy. At the same time interest rates were falling in Japan, stock and real estate prices were collapsing, thus providing another indication that Japanese monetary policy was not easy. Recognizing the second lesson might have led Japanese monetary policymakers to recognize sooner that they needed a more expansionary monetary policy.
The third lesson indicates that monetary policy can still be effective even if short-term interest rates are near zero. Officials at the Bank of Japan have frequently claimed that they have been helpless in stimulating the economy, because short-term interest rates had fallen to near zero. Recognizing that monetary policy can still be effective even when interest rates are near zero, as the third lesson suggests, would have helped them to take monetary policy actions that would have stimulated aggregate demand by raising other asset prices and inflationary expectations.
The fourth lesson indicates that unanticipated fluctuations in the price level should be avoided. If the Japanese monetary authorities had adhered to this lesson, they might have recognized that allowing deflation to occur could be very damaging to the economy and would be inconsistent with the goal of price stability. Indeed, critics of the Bank of Japan have suggested that the bank should announce an inflation target to promote the price stability objective, but the bank has resisted this suggestion.
Heeding the advice from the four lessons in the previous section might have led to a far more successful conduct of monetary policy in Japan in recent years.
Posted by Mark Thoma on Wednesday, March 19, 2008 at 12:27 AM in Economics, Financial System, Monetary Policy |
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