Low r*
Vice-Chair Stan Fischer gave a great speech on Sunday. His basic message: There are good reasons to believe that for a long time to come, the equilibrium real interest rate r* (consistent with full employment and 2% inflation) will be much lower than was true historically. So, we need to be thinking about how to deal with this outcome.
I agree completely with the Vice-Chair — but that’s not surprising since I’ve been making this point since April 2013!
My take-aways from the Vice-Chair’s speech are in black and my comments are in red.
Monetary policy is likely to be more constrained by the zero lower bound than was true historically. (I’ve been an economist for twenty-eight years. The US economy has been at the zero lower bound for about a quarter of that time, from 2008-15. It should be very scary for any economist under the age of 55 to think that we’re talking about the zero lower bound mattering even more going forward.)
The Fed could respond to this constraint in at least two ways. The Fed could increase its inflation target. (But would such a move be credible? And/or politically viable?)
The Fed could follow the lead of European central banks, and be wiling to lower the fed funds rate target to a negative number. (At a minimum, the Fed should learn quickly how to undertake this policy step on short notice. Note that, in terms of policy headroom, a lower bound of -100 basis points is equivalent to raising the inflation target by 100 basis points, without the associated costs of higher inflation.)
There are also fiscal responses that could help raise r*. For example, Congress could undertake needed investment in human and physical infrastructure. (I would add that Congress could also provide much better tax incentives for private physical investment, especially for R&D.)
With such low interest rates, the debate over monetary policy and financial stability will continue to be a very live one. (In my view, there is little empirical evidence that tightening monetary policy by any plausible magnitude will restrain financial excesses. There is only loose talk about 2003-06 US monetary policy.)
My main comment on the speech: the zero lower bound could well be a material consideration for US monetary policy for years to come. That conclusion makes the following question paramount. What lessons can the FOMC learn from its most recent stay at the zero lower bound about policy choices and communications so that it can engender better US economic performance during future zero lower bound episodes? I’ve given my own answer to this question here - but the question matters far more than my answer.
N. Kocherlakota
January 3, 2016, Rochester, NY
Follow me on Twitter @kocherlakota009. Please address media enquiries and non-academic speaking requests to Monique Patenaude (monique.patenaude@rochester.edu and 585-276-3693).