Monetary policy at the zero bound

<p><em>Romesh Vaitilingam interviews Andrew Levin for Vox</em></p>
<p><em>November 2010</em></p>
<p><em>Transcription of an VoxEU audio interview [http://www.voxeu.org/index.php?q=node/5848]</em></p>
<p><strong>Romesh Vaitilingam</strong>: Welcome to Vox Talks, a series of audio interviews with leading economists from around the world. My name is Romesh Vaitilingam, and today's interview is with Andrew Levin from the Federal Reserve. Andrew and I met in August 2010 at the European Economic Association's annual meetings in Glasgow, where he had presented a paper called &quot;Limitations on the Effectiveness of Forward Guidance at the Zero Lower Bound.&quot; He began by explaining the background to his study, in research over the past 10 years, on optimal monetary policy at the zero bound.</p>
<p><strong>Andrew Levin</strong>: The consensus of the literature that was started about 10 years ago, various papers looking at optimal policy at the zero lower bound, including some very nice work at the Bank of Japan and a very well known paper by Gauti Eggertsson and Mike Woodford in the Brookings papers. And the consensus from that literature seemed to be that, regardless of the size of the shock or the persistence of the shock, that monetary policy could be very effective in stabilizing the economy, even with a constraint of the zero bound, by providing forward guidance about the future path of policy.</p>
<p>In effect, committing to providing more stimulus in the future when the fund's rate or the policy rate's no longer constrained by the zero bound, that stimulus has a contemporaneous effect by lowering current long term real interest rates. And in effect, in these papers, the ability of those expectations about the future policy path could largely offset the current adverse effects on aggregate demand and keep the economy very close to its potential output level and keep inflation very close to the target level.</p>
<p>So that raises a couple of questions. One, this Great Recession episode that we've had that started a couple of years ago has had very severe consequences on many industrial economies. We see the estimates are that the output gaps in Britain, the Euro Area, Canada, Japan, and the United States have all been five or six percent, in some cases, even more than that, much, much larger than anything experienced during the Great Moderation era.</p>
<p>In fact, in our paper, we tabulate that the standard deviation of the output gap from the early '90s through 2006 or '07 was typically around one percentage point for most of these countries. So output gaps of five or six percent, you're out into the tails of the distribution.</p>
<p>And these shocks all seem to be very persistent. The levels of the output gap in 2010 are generally very similar to what they were in 2009, because GDP growth in most of these countries has continued to be fairly moderate over the last year, so not really making much headway in bringing the output back to our potential. And the projections of professional forecasters are that unemployment's going to remain high for years to come.</p>
<p>So, in contrast to the results of that earlier literature, it seems like, even with the efforts of monetary and fiscal policies over the last couple years in these industrial countries, that still the shocks had very severe adverse effects on economic activity that are expected to last for a long time.</p>
<p>And so one aspect of our research in this paper I presented this morning was to try to understand why. Is it because monetary policy was far from optimal and, in some sense, didn't follow the prescriptions given in this consensus literature? Or are there some limitations? Which, in fact, is what we found. There are significant limitations on the ability of monetary policy, even with expectations about the future path of policy, to offset an adverse shock when you're constrained by the zero bound.</p>
<p>What turns out to be crucial is, if it's a large enough shock that is expected to depress aggregate demand for a relatively long time, and if the economy is relatively interest sensitive in a sense of empirically plausible parameter specifications, then it turns out that forward guidance is still helpful, but it's not a panacea, and you can still get very large and persistent effects on the real economy, similar to the kind that we've seen in many countries in the last few years. Again, that points to the idea that it's not necessarily a failure of monetary policy. It's just reflecting the constraints and limitations on monetary policy.</p>
<p>Another key question that we were interested in is why many central banks, including the Bank of England, the ECB, the Bank of Japan, and the Federal Reserve, have been using non-traditional forms of monetary policy. The Bank of Japan refer to it as quantitative easing, Chairman Bernanke typically refers to it as credit easing. Each central bank has its own nomenclature for referring to these.</p>
<p>In the case of the Federal Reserve, it was large scale purchases of mortgage backed securities and treasuries. In the case of the ECB, it was covered bonds. In the case of the Bank of England, it's gilts. But in each case, aimed at providing additional stimulus to private credit markets through these large scale asset purchases.<br />
And in this earlier literature, there's no clear rationale for why a central bank would want to do that. In effect, in the earlier literature, you can accomplish everything through the forward guidance, the promises about the future path of policy. There's really no need for quantitative easing or credit easing.</p>
<p>But once you recognize that, again, for large and persistent adverse shocks to aggregate demand that put you at the zero bound for a relatively long time, the ability of forward guidance to offset that shock is limited, and therefore the rationale for non conventional policy tools becomes much more compelling.</p>
<p>We don't analyze the non-traditional tools in this paper, but we do think that analysis like this is helpful in playing the direction for further analysis that's really needed to incorporate those kind of non-traditional policy tools into macro models, and to think about what's the optimal combination of forward guidance, non-traditional policy tools, and possibly fiscal policy, all working together to try to provide the best possible stabilization outcomes, which still might not be ideal but at least constrained optimal outcomes.</p>
<p>So that's the gist of what we've been doing.</p>
<p><strong>Romesh</strong>: Is it partly an issue that this crisis has given a whole new testing ground for these ideas that started 10 years ago, when before that it was only really Japan that had gotten into this position of actually facing the zero bound, and now all the developed economies are in this position?</p>
<p><strong>Andrew</strong>: Yeah, that's a great question. I think there's two aspects to it. One is that we need to give a lot of credit to economists at the Bank of Japan and other Japanese universities who were thinking hard and doing a lot of really valuable research about policy at the zero bound back 10 years ago when there wasn't a lot of interest in it among economists in other industrial countries. And now we recognize it's not just a Japanese problem. It's potentially an issue for many industrial countries. I think another interesting point about this is that the work that was done in the US 10 years ago, some of it was using the FRBUS model, work that Dave Reifschneider and John Williams did that's been published in a JMCB paper, and work that people did with small scale DGE models, there's a nice paper by Klaus Adam and Roberto Billi where they do this.</p>
<p>The typical findings in that literature was that with a steady state real interest rate of two percent and an inflation target of two percent, which meant that the policy rate would typically be around four percent in normal times, that you needed very large shocks to hit the zero bound at all, and when you did, you'd only be constrained by it for a couple of quarters, something more or less like what happened in 2003 and 2004 in the United States.</p>
<p><strong>Romesh</strong>: And in that kind of situation, forward guidance would be fine, because you were just saying they're a few months ahead.</p>
<p><strong>Andrew</strong>: Yeah. And the shocks just aren't that bad and the outcomes aren't that bad, and the need to resort to non-traditional policies or some unusual fiscal policies would really be minimal. So I think that sense of what the Great Moderation era looks like did also have a big influence on this literature. All the models were calibrated to Great Moderation type shocks. Well, now we know. The financial crisis can be much worse than any type of shock that you'd see during a Great Moderation. And therefore, again, the potential implications for policy could be quite different.</p>
<p>Going forward, I guess I hope that we don't have another financial crisis for a long, long time. And so there's some scenario where, five or 10 years from now, people forget about the zero bound again and resort to methods that are well designed for a Great Moderation period.</p>
<p>But I also have a lot of sympathy for the analysis that Robert Lucas gave in a lecture called &quot;Understanding Business Cycles.&quot; Part of his analysis was emphasizing that small shocks to the economy and small movements in aggregate consumption probably weren't that important for welfare. I think that's still an open question. There's been a lot of interesting work, 25 years since his lectures, about why even moderate business cycles may, in fact, be more costly.</p>
<p>But the other part of his lecture was emphasizing that these rare events like the Great Depression are clearly very costly for welfare and that economists ought to, basically, be doing more risk management, I think, of trying to anticipate what can go wrong and how to minimize those risks and how to ensure that the economy makes it through if you do have a large shock like that.</p>
<p>And so, in that sense, I hope that even 10 years from now, even if things go back to normal and we get back into a Great Moderation, that macroeconomists and monetary economists will be more risk oriented than they might have been five or 10 years ago. Because, again, as Lucas said, those are the very costly events that, if economists can help try to figure out how to avoid them, there might be big payoffs in terms of welfare.</p>
<p><strong>Romesh</strong>: At this point, where you saw we're at the zero bound and we have these non-standard, non-traditional policies in place, when it comes to tightening, monetary policymakers have two things they can do different from their normal one thing of shifting the interest rate. How should we start thinking about those kinds of issues, about whether you withdraw the credit easing first or whether you raise the interest rate first?</p>
<p><strong>Andrew</strong>: These are all active questions, so this is where I can just emphasize that I'm only giving my own views. There have been a number of speeches of Federal Reserve policymakers on this question of what's often referred to as the exit strategy. So, for example, earlier this spring, Chairman Bernanke gave a couple of speeches about the exit strategy. I think the view that he expressed there was that once the central bank has the ability to pay interest on reserves, it's also the case that that has significant implications for the mix of policy tools because, in principle, a central bank can maintain a larger balance sheet even after it tightens the stance of policy through the short term interest rate. There's a cost, of course, to maintain a large balance sheet, in the sense that the central bank may be paying less seigniorage to the fiscal authorities.</p>
<p>And so, over time, this becomes a fiscal issue that's relevant for the elected officials, and ultimately to the public: what responsibilities should the central bank have, and what are the implications of those responsibilities for the balance sheet? In the United States, there are some policymakers who feel strongly that the central bank should not engage in activities that are directed towards specific private credit markets. Those policymakers would be opposed to getting involved in mortgage markets, for example, and don't think those should be on a central bank's balance sheet. But there are other policymakers who have different views.</p>
<p>And so I think these are areas where there is a need for more research and, over time, some more public debate about, again, what central bank responsibilities should be delegated and so forth.</p>
<p><strong>Romesh</strong>: And what about the interactions with fiscal policy? Because, certainly, in Europe, you have the exit strategy in place from the fiscal stimulus, very strongly in some countries, including my own in the UK but also in many Euro Area countries. And I guess the hope is there that the Central Bank keeps the interest rates low, they keep the quantitative easing programs, the &quot;enhanced credit support&quot; programs as they call them in Europe, in place. But there's interesting issues there about the interactions of these two because they're governed by a different authority: you have the public authority in terms of the government on one hand and independent central banks on the other.</p>
<p><strong>Andrew</strong>: I think a clear lesson from past experience is that there is a need for fiscal authorities and monetary authorities to coordinate their policies and to communicate with each other and not work at counter purposes. There's a fascinating debate going on right now about how alternative fiscal approaches affect the macroeconomy. And it's not a settled debate. There are some people who think that moving in the direction of reducing the expected future path of fiscal deficits and providing greater fiscal stability can actually provide stimulus in the near term. And obviously, there are others who think that that reduces aggregated demand and puts the economy in a worse position that might need to be offset by monetary policy.</p>
<p>These different views, oftentimes, are using the same model and very similar methods. So that's why I say I don't think it's settled right now. Maybe the UK, the measures that are being taken actually will stimulate aggregate demand relative to otherwise. There's fascinating empirical research that suggests that could be the case.</p>
<p>There is a question on my mind, again, thinking in terms of risk management. What if the economy weakens again? What can policymakers do to make sure that we do not get into another Great Depression, that we make sure that prices don't start falling?</p>
<p>I still subscribe to Friedman's saying that, 'inflation's everywhere and always a monetary phenomenon', which means that central banks really have to take responsibility for making sure that inflation remains as close as possible to their stated objective. They can't necessarily control the real economy perfectly. There can be structural changes that influence economic growth and unemployment over time. But in the case of an aggregate demand shock, there's no trade off between stabilizing economic activity and stabilizing inflation.</p>
<p>And so, if you're in a situation where inflation is trending downward and resource slack seems to be very high, both of those signals are pointing in the same direction, which is that it's ultimately the central bank's responsibility to maintain price stability. When you're constrained by the zero bound, what are the non-traditional tools that the central bank can use to make sure that you don't fall into a deflationary spiral?</p>
<p>So, again, I think these are very important questions. They're interesting questions. I hope a lot of academics will continue to do research on them. But I think we're not out of the woods yet. We're not ready to relax and go back to Great Moderation types of research yet, either.</p>
<p><strong>Romesh</strong>: Can I ask you one final question, Andy, about central bank communication and central bank transparency? That's something that's evolved very much in the recent couple of decades, I guess. And I guess that informed that literature you mentioned at the beginning of our conversation about the zero bound, about the Fed being able to provide forward guidance, or other Central Banks being able to provide forward guidance. Do you think that issue changes somewhat when you're at the zero bound and you're using these non-standard, non-traditional policies? Do you think the same emphasis on communication and transparency is as essential, or perhaps you might want to rein back on that a bit?</p>
<p><strong>Andrew</strong>: Well, I think of Franklin Roosevelt. When he came into office, he said, &quot;We have nothing to fear but fear itself.&quot; And I think what that captures is the sense that uncertainty and lack of security are the enemy. When you're in a difficult situation, those factors make things worse. So I think that in a situation where the economy's been hit by some severe, adverse shocks, and it could be a financial crisis, it could be other types of geopolitical shocks, that's the time that the central bank needs to be as clear as possible in its strategy and its communication so that it contributes to reducing uncertainty on the part of financial markets, reducing uncertainty on the part of people who are setting wages and prices, and a sense of security on the parts of households and firms in making their spending decisions.</p>
<p>So I think, if anything, the case for central bank transparency and clarity of communication is strongest when you're facing a crisis or when you're recovering from a crisis, to try to help minimize the uncertainty, or at least make sure the central bank's not adding to it.</p>
<p><strong>Romesh</strong>: Andrew Levin, thank you very much.</p>
<p><strong>Andrew</strong>: OK, thank you. <br />
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