Federal Reserve Policy in a World of Low Interest Rates

Download or read book Federal Reserve Policy in a World of Low Interest Rates written by Eric R. Sims and published by . This book was released on 2020 with total page 15 pages. Available in PDF, EPUB and Kindle. Book excerpt: The Federal Reserve (Fed) is tasked with maintaining price stability and achieving maximum employment. In practice, over the last decades the Fed has sought to achieve its objectives primarily through the manipulation of a short-term inter-bank interest rate, the federal funds rate (FFR).At the height of the Great Recession of 2007-2009, the Fed pushed its benchmark policy rate to zero. With its principal tool unavailable, the Fed resorted to a sequence of unconventional policy actions in attempt to provide further stimulus to the economy. These actions included large-scale asset purchases (more commonly referred to as quantitative easing, or QE) and forward guidance. These programs were viewed by most as solutions to the temporary problem of the zero lower bound (ZLB) on the short-term policy rate. Market participants never expected the ZLB to last more than a couple of years (Bauer and Rudebusch 2016; Wu and Xia 2016), but in actuality the FFR was at zero for seven years. And though the Fed began raising the FFR at the end of 2015, it has since cut it twice, and at present the FFR sits less than two hundred basis points above zero. Markets are expecting further rate cuts in the near future.A substantial body of research finds that the so-called natural rate of interest, or sometimes “r-star,” is on a continuing secular downward trend. While the Laubach and Williams (2003) estimate of r-star declined substantially in the wake of the Great Recession, this decline is part of a longer-run downward trend. In standard models, optimal policy entails adjusting the policy rate to track movements in the natural rate. With the natural rate hovering so close to zero, there is little room for conventional policy rate cuts should the need arise.All signs therefore point towards an extended period in which interest rates are significantly lower than their average levels from the 1980s to 2000s. This means that the problem of the ZLB and the inability to push the FFR down in response to deteriorating economic conditions is likely to arise again. As a consequence, the Fed must move away from its conventional operating framework - for example, by significantly raising its inflation target, experimenting with negative rates, or more regularly using unconventional tools like QE as a substitute for conventional rate cuts at the ZLB. Which of these options should the Fed and other central banks choose?