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Paper by Governor Ben S. Bernanke and Vincent R.
Reinhart, Director, Division of Monetary Affairs*
Presented at the International Center for Monetary and Banking Studies Lecture,
Geneva, Switzerland
January 14, 2004
Presented at the Meetings of the American Economic Association, San Diego, California
January 3, 2004
Conducting Monetary Policy at Very Low Short-Term Interest Rates
Can monetary policy committees, accustomed to describing their plans and actions in terms
of the level of a short-term nominal interest rate, find effective means of conducting and
communicating their policies when that rate is zero or close to zero? The very low levels of
interest rates in Japan, Switzerland, and the United States in recent years have stimulated
much interesting research on this question, and some has been applied in the field.
Moreover, their minds concentrated by the possibility of having the policy rate pinned at
zero, central bankers have responded flexibly, making changes in their operating procedures
and communications strategies. Our purpose in this paper is to give a brief progress report
and overview of current thinking on the conduct of monetary policy when short-term
interest rates are very low or even zero.1
Monetary policy works for the most part through financial markets. Central bank actions are
designed in the first instance to influence asset prices and yields, which in turn affect
economic decisions and thus the evolution of the economy. When the short-term policy rate
is at or near zero, the conventional means of effecting monetary ease--lowering the target for
the policy rate--is no longer feasible, but monetary policy is not impotent. In this paper we
will discuss three alternative (but potentially complementary) monetary strategies for
stimulating the economy that do not involve changing the current value of the policy rate.
Specifically, these alternatives involve (1) providing assurance to financial investors that
short rates will be lower in the future than they currently expect, (2) changing the relative
supplies of securities (such as Treasury notes and bonds) in the marketplace by shifting the
composition of the central bank's balance sheet, and (3) increasing the size of the central
bank's balance sheet beyond the level needed to set the short-term policy rate at zero
("quantitative easing"). In the final section, we briefly discuss the macroeconomic costs and
benefits of very low interest rates, an issue that bears on the question of whether the central
bank should take the policy rate all the way to zero before undertaking some of the
alternatives we describe.
I. Shaping Interest-Rate Expectations
The pricing of long-lived assets, such as long-term bonds and equities, depends on the entire
expected future path of short-term interest rates as well as on the current short-term rate.
Prices and yields of long-lived assets are important determinants of economic behavior
because they affect incentives to spend, save, and invest. Thus, a central bank may hope to
affect financial markets and economic activity by influencing financial market participants'
expectations of future short-term rates. Important recent research has examined this
potential channel of influence in fully articulated models based on optimizing behavior; see
Michael Woodford (2003, chapter 6), Lars Svensson (2001), and Gauti Eggertson and
Woodford (2003). This literature suggests that, even with the overnight nominal interest rate
at zero, a central bank can impart additional stimulus by offering some form of commitment
to the public to keep the short rate low for a longer period than previously expected. This
commitment, if credible, should lower yields throughout the term structure and support
other asset prices.
In principle, the central bank's policy commitment could take either of two forms:
unconditional and conditional. An unconditional commitment is a pledge by the central bank
to hold short-term rates at a low level for a fixed period of calendar time. In this case,
additional easing would take the form of lengthening the period of policy commitment.
However, given the many shocks that the economy is heir to, as well as other imponderables
that affect the outlook, a policymaking committee might understandably be reluctant to tie
its hands by making an unconditional promise, no matter how nuanced, about policy actions
far into the future. An alternative strategy is to make a conditional policy commitment, one
that links the duration of promised policies not to the calendar but to the evolution of
economic conditions. For example, policy ease could be promised until the committee
observes sustained economic growth, substantial progress in trimming economic slack, or a
period of inflation above a specified floor.
In practice, central banks appear to appreciate the importance of influencing market
expectations about future policy. For example, in May 2001, with its policy rate virtually at
zero, the Bank of Japan promised that it would keep its policy rate at zero for as long as the
economy experienced deflation--a conditional policy commitment. More recently, the Bank
of Japan has been more explicit about the conditions under which it would begin to raise
rates; for example, it has been specified that a change from deflation to inflation that is
perceived to be temporary will not provoke a tightening.2 In the United States, the August
2003 statement of the Federal Open Market Committee that "policy accommodation can be
maintained for a considerable period" is another example of commitment. The close
association of this statement with the Committee's expressed concerns about "unwelcome
disinflation" implied that this commitment was conditioned on the assessment of the
economy. The conditional nature of the commitment was sharpened in the Committee's
December statement, which explicitly linked continuing policy accommodation to the low
level of inflation and the slack in resource use.3 More generally, in recent years central
banks have devoted enormous effort to improving their communications and transparency; a
major benefit of such efforts should be a greater ability to align market expectations of
policy with the policymaking committee's own intentions.
Of course, policy commitments can influence future expectations only to the extent that they
are credible. Various devices might be employed to enhance credibility; for example, the
central bank can make securities purchases or issue financial options that make it quite
costly, in financial terms, to renege on its commitments (Clouse et al., 2003). An objection
to this strategy is that it is not entirely clear why a central bank, which has the power to print
money, should be overly concerned about its financial gains and losses. Eggertsson and
Woodford (2003) point out that a government can more credibly promise to carry out
policies that raise prices when (1) the government debt is large and not indexed to inflation
and (2) the central bank values the reduction in fiscal burden that reflationary policies will
bring (for example, because it may reduce the future level of distortionary taxation).
Ultimately, however, the central bank's best strategy for building credibility is to ensure that
its deeds match its words, thereby building trust in its pronouncements. The requirement that
deeds match words has the consequence that the shaping of market expectations is not an
independent instrument of policy in the long run.
II. Altering the Composition of the Central Bank's Balance Sheet
Central banks typically hold a variety of assets, and the composition of assets on the central
bank's balance sheet offers another potential lever for monetary policy. For example, the
Federal Reserve participates in all segments of the Treasury market, with most of its current
asset holdings of about $670 billion distributed among Treasury securities with maturities
ranging from four weeks to thirty years. Over the past fifty years, the average maturity of
the Federal Reserve System's holdings of Treasury debt has varied considerably within a
range from one to four years. As an important participant in the Treasury market, the
Federal Reserve might be able to influence term premiums, and thus overall yields, by
shifting the composition of its holdings, say from shorter- to longer-dated securities. In
simple terms, if the liquidity or risk characteristics of securities differ, so that investors do
not treat all securities as perfect substitutes, then changes in relative demands by a large
purchaser have the potential to alter relative security prices. (The same logic might lead the
central bank to consider purchasing assets other than Treasury securities, such as corporate
bonds or stocks or foreign government bonds. The Federal Reserve is currently authorized
to purchase some foreign government bonds but not most private-sector assets, such as
corporate bonds or stocks.)
Perhaps the most extreme example of a policy keyed to the composition of the central bank's
balance sheet is an announced ceiling on some longer-term yield below the prevailing rate.
This policy entails (in principle) an unlimited commitment to purchase the targeted security
at the announced price. (To keep the overall size of its balance sheet unchanged, the central
bank would have to sell other securities in an amount equal to the purchases of the targeted
security.) Obviously, such a policy would signal strong dissatisfaction on the part of the
policymaking committee with current market expectations of future policy rates.
Whether policies based on manipulating the composition of the central bank balance sheet
can be effective is a contentious issue. The limited empirical evidence generally suggests
that the degree of imperfect substitutability within broad asset classes, such as Treasury
securities, is not great, so that changes in relative supplies within the range of U.S.
experience are unlikely to have a major impact on risk premiums or term premiums
(Reinhart and Sack, 2001). If this view is correct, then attempts to enforce a floor on the
prices of long-dated Treasury securities (for example) could be effective only if the target
prices were broadly consistent with investor expectations of future values of the policy rate.
If investors doubted that rates would be kept low, the central bank would end up owning all
or most of those securities. Moreover, even if large purchases of, say, a long-dated Treasury
security were able to affect the yield on that security, the policy may not have significant
economic effects if the targeted security became "disconnected" from the rest of the term
structure and from private rates, such as mortgage rates.
Yet another complication affecting this type of policy is that the central bank's actions
would have to be coordinated with the central government's finance department to ensure
that changes in debt-management policies do not offset the attempts of the central bank to
affect the relative supplies of securities. According to James Tobin, the Federal Reserve's
failure to coordinate adequately with the Treasury was the undoing of "Operation Twist" in
1963 (Tobin, 1973, pp. 32-33).
Despite these objections, we should not fail to note that policies based on changing the
composition of the central bank's balance sheet have been tried in the United States. From
1942 to 1951, the Federal Reserve enforced rate ceilings at two and sometimes three points
on the Treasury yield curve. This objective was accomplished with only moderate increases
in the Federal Reserve's overall holdings of Treasury securities, relative to net debt
outstanding; moreover, there is little evidence that the targeted yields became
"disconnected" from other public or private yields. The episode is an intriguing one, but
unfortunately the implications for current policy are not entirely straightforward. We know
that, by 1946, the Federal Reserve System owned almost nine-tenths of the (relatively small)
stock of Treasury bills, suggesting that at the short end, the ceiling on the bill rate was a
binding constraint. In contrast, the Federal Reserve's relative holdings of longer-dated
Treasury notes and bonds fell over the period, although the rate ceilings at these longer
maturities were not breached until inflation pressures led to the Fed-Treasury Accord and
the abandonment of the pegging policy in 1951. The conventional interpretation is that longrun policy expectations must have been consistent with the ceilings at the more distant
points on the yield curve. Less clear is the extent to which the pegging policy itself
influenced those policy expectations.
Probably the safest conclusion about policies based on changing the composition of the
central bank's balance sheet is that they should be used only to supplement other policies,
such as an attempt (for example, through a policy commitment) to influence expectations of
future short rates. This combined approach allows the central bank to enjoy whatever
benefits arise from changing the relative supplies of outstanding securities without risking
the problems that may arise if the yields desired by the central bank are inconsistent with
market expectations.
III. Expanding the Size of the Central Bank's Balance Sheet
Besides changing the composition of its balance sheet, the central bank can also alter policy
by changing the size of its balance sheet; that is, by buying or selling securities to affect the
overall supply of reserves and the money stock. Of course, this strategy represents the
conventional means of conducting monetary policy, as described in many textbooks. These
days, most central banks choose to calibrate the degree of policy ease or tightness by
targeting the price of reserves--in the case of the Federal Reserve, the overnight federal
funds rate. However, nothing prevents a central bank from switching its focus from the price
of reserves to the quantity or growth of reserves. When stated in terms of quantities, it
becomes apparent that even if the price of reserves (the federal funds rate) becomes pinned
at zero, the central bank can still expand the quantity of reserves. That is, reserves can be
increased beyond the level required to hold the overnight rate at zero--a policy sometimes
referred to as "quantitative easing." Some evidence exists that quantitative easing can
stimulate the economy even when interest rates are near zero; see, for example, Christina
Romer's (1992) discussion of the effects of increases in the money supply during the Great
Depression in the United States.
Quantitative easing may affect the economy through several possible channels. One
potential channel is based on the premise that money is an imperfect substitute for other
financial assets (in contrast to the view discussed in the previous section that emphasizes the
imperfect substitutability of various nonmoney assets). If this premise holds, then large
increases in the money supply will lead investors to seek to rebalance their portfolios,
raising prices and reducing yields on alternative, non-money assets. Lower yields on longterm assets will in turn stimulate economic activity. The possibility that monetary policy
works through portfolio substitution effects, even in normal times, has a long intellectual
history, having been espoused by both Keynesians (Tobin, 1969) and monetarists (Brunner
and Meltzer, 1973). Recently, Javier Andres, J. David Lopez-Salido, and Edward Nelson
(2003) have shown how these effects might work in a general equilibrium model with
optimizing agents. The practical importance of these effects remains an open question,
however.
Quantitative easing may also work by altering expectations of the future path of policy rates.
For example, suppose that the central bank commits itself to keeping reserves at a high
level, well above that needed to ensure a zero short-term interest rate, until certain economic
conditions obtain. Theoretically, this action is equivalent to a commitment to keep interest
rates at zero until the economic conditions are met, a type of policy we have already
discussed. However, the act of setting and meeting a high reserves target is more visible,
and hence may be more credible, than a purely verbal promise about future short-term
interest rates. Moreover, this means of committing to a zero interest rate will also achieve
any benefits of quantitative easing that may be felt through non-expectational channels.
Lastly, quantitative easing that is sufficiently aggressive and that is perceived to be longlived may have expansionary fiscal effects. So long as market participants expect a positive
short-term interest rate at some date in the future, the existence of government debt implies
a current or future tax liability for the public. In expanding its balance sheet by open-market
purchases, the central bank replaces public holdings of interest-bearing government debt
with non-interest-bearing currency or reserves. If the open-market operation is not expected
to be reversed too quickly, this exchange reduces the present and future interest costs of the
government and the tax burden on the public. (Effectively, this process replaces a direct tax,
say on labor, with the inflation tax.) Auerbach and Obstfeld (2003) have analyzed the fiscal
and expectational effects of a permanent increase in the money supply along these lines.
Note that the expectational and fiscal channels of quantitative easing, though not the
portfolio substitution channel, require the central bank to make a credible commitment to
not reverse its open-market operations, at least until certain conditions are met. Thus, this
approach also poses communication challenges for monetary policy makers.
Japan once again provides the most recent case study. In the past two years, current account
balances held by commercial banks at the Bank of Japan have increased about five-fold, and
the monetary base has risen to almost 30 percent of nominal GDP. While deflation appears
to have eased in Japan recently, it is difficult to know how much of the improvement is due
to monetary policy, and, of the part due to monetary policy, how much is due to the zerointerest-rate policy and how much to quantitative easing. The experience of the United
States with quantitative policies is limited to the period 1979 to 1982, when the Federal
Reserve targeted nonborrowed reserves. Of course, nominal interest rates were not close to
zero at that time. The U.S. experience does suggest, however, that the demand for reserves
may be sufficiently erratic that the effects of quantitative policies may be intrinsically hard
to calibrate.
IV. Sequencing and the "Costs" of Low Interest Rates
The forms of monetary stimulus described above can be used once the overnight rate has
already been driven to zero or as a way of driving the overnight rate to zero. However, a
central bank might choose to rely on these alternative policies while maintaining the
overnight rate somewhat above zero. For example, monetary policy makers might attempt to
influence market expectations of future short rates as an alternative to changing the current
setting of the overnight rate. Another possibility is to try to affect term premiums,
expectations of future rates, or both, by changing the composition of securities held by the
central bank. (Unlimited expansion of the total volume of securities held by the central bank
is not compatible, of course, with a positive overnight rate.) The appropriate sequencing of
policy actions depends on the perceived costs associated with very low or zero overnight
interest rates, as well as on operational considerations and estimates of the likely effects of
alternative combinations of policies on the economy.
What costs are imposed on society by very low short-term interest rates? Observers have
pointed out that rates on financial instruments typically priced below the overnight rate,
such as liquid deposits, shares in money market mutual funds, and collateralized borrowings
in the "repo" market, would be squeezed toward zero as the policy rate fell, prompting
investors to seek alternatives. Short-term dislocations might result, for example, if funds
flowed in large amounts from money market mutual funds into bank deposits. In that case,
some commercial paper issuers who have traditionally relied on money market mutual funds
for financing would have to seek out new sources, while banks would need to find
productive uses for the deposit inflows and perhaps face changes in regulatory capital
requirements. In addition, liquidity in some markets might be affected; for example, the
incentive for reserve managers to trade federal funds diminishes as the overnight rate falls,
probably thinning brokering in that market.
In thinking about the costs associated with a low overnight rate, one should bear in mind the
message of Milton Friedman's classic essay on the optimal quantity of money (Friedman,
1969). Friedman argued that an overnight interest rate of zero is optimal, because a zero
opportunity cost of liquidity eliminates the socially wasteful use of resources to economize
on money balances. From this perspective, the costs of low short-term interest rates can be
seen largely as adjustment costs, arising from the unwinding of schemes designed to make
holding transactions balances less burdensome. These costs are real but are also largely
transitory and have limited sectoral impact. Moreover, to the extent that the affected
institutions have economic functions other than helping clients economize on money
balances (for example, if some money market mutual funds have a comparative advantage
in lending to commercial paper issuers), there is scope for repricing that will allow these
services to continue to be offered. Thus there seems to be little reason for central banks to
avoid bringing the policy rate close to zero if the economic situation warranted.
A quite different argument for engaging in alternative monetary policies before lowering the
overnight rate all the way to zero is that the public might interpret a zero instrument rate as
evidence that the central bank has "run out of ammunition." That is, low rates risk fostering
the misimpression that monetary policy is ineffective. As we have stressed, that would
indeed be a misimpression, as the central bank has means of providing monetary stimulus
other than the conventional measure of lowering the overnight nominal interest rate.
However, it is also true that the considerable uncertainty that surrounds the use of these
alternative measures does make the calibration of policy actions more difficult. Moreover,
given the important role for expectations in making many of these policies work, the
communications challenges would be considerable. Given these risks, policymakers are well
advised to act preemptively and aggressively to avoid facing the complications raised by the
zero lower bound.
REFERENCES
Andres, Javier; López-Salido, J. David and Nelson, Edward. "Tobin's Imperfect Asset
Substitution in Optimizing General Equilibrium," presented at the JMCB/Federal Reserve
Bank of Chicago James Tobin Symposium, November 14-15, 2003.
Auerbach, Alan J. and Obstfeld, Maurice. "The Case for Open-Market Purchases in a
Liquidity Trap." Working paper, University of California, Berkeley, 2003
Bernanke, Ben. "Deflation: Making Sure 'It' Doesn't Happen Here." Remarks before the
National Economists' Club, Washington, DC, November 21, 2002.
Bernanke, Ben. "Some Thoughts on Monetary Policy in Japan." Address to the Japan
Society of Monetary Economics, Tokyo, May 31, 2003.
Brunner, Karl and Meltzer, Allan. "Mr. Hicks and the 'Monetarists'," Economica, February
1973, 40(157), pp. 44-59.
Clouse, James; Henderson, Dale; Orphanides, Athanasios; Small, David H. and Tinsley,
P.A. "Monetary Policy When the Nominal Short-Term Interest Rates Is Zero." Topics in
Macroeconomics, 2003, 3(1), article 12, pp. n.a.
Eggertsson, Gauti and Woodford, Michael. "The Zero Bound on Interest Rates and Optimal
Monetary Policy." Brookings Papers on Economic Activity, 2003, (1), pp. 139-233.
Friedman, Milton. The Optimum Quantity of Money and Other Essays. Chicago: Aldine,
1969.
Reinhart, Vincent and Sack, Brian. "The Economic Consequences of Disappearing
Government Debt." Brookings Paper on Economic Activity, 2000, (2), pp. 163-209.
Romer, Christina. "What Ended the Great Depression?" Journal of Economic History,
December 1992, 52(4), pp. 757-84.
Svensson, Lars E. O. "The Zero Bound in an Open Economy: A Foolproof Way of Escaping
from a Liquidity Trap." Monetary and Economic Studies, Special Edition, February 2001,
19, pp. 277-312.
Tobin, James. "A General Equilibrium Approach to Monetary Theory." Journal of Money,
Credit, and Banking, February 1969, 1(1), pp. 15-29.
Tobin, James. The New Economics One Decade Older. Princeton, NJ: Princeton University
Press, 1974.
Woodford, Michael. Interest Rates and Prices: Foundations of a Theory of Monetary
Policy. Princeton, NJ: Princeton University Press, 2003.
Footnotes
* Board of Governors of the Federal Reserve System, Washington, D.C. We have benefited
from the research of, and many discussions with, numerous colleagues. However, the views
expressed here are our own and not necessarily shared by anyone else in the Federal Reserve
System. Return to text
1. See Bernanke (2002) and Clouse et al. (2003) for earlier discussions of these issues.
Return to text
2. For a recent appraisal of monetary policy options in Japan, see Bernanke (2003). Return
to text
3. 2003 FOMC statements and minutes. Return to text
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