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"Permazero"
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November 12, 2015
A simple and prudent approach to current monetary policy
is to move the policy settings closer to normal levels now
that the goals of policy have been attained, St. Louis Fed
President James Bullard said during the Cato Institute's
33rd Annual Monetary Conference in Washington, D.C.
However, with the topic of the conference being
"Rethinking Monetary Policy," he also discussed the
consequences of a situation in which the zero interest rate
policy remains a persistent feature of the economy.
Speech: pdf | text (below)
Read the related article in Federal Reserve Bank of St.
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Permazero1
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James Bullard
President and CEO, Federal Reserve Bank of St. Louis
Rethinking Monetary Policy
Cato Institute–33rd Annual Monetary Conference
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Introduction
It is a pleasure to be here today to discuss this important
conference topic, "Rethinking Monetary Policy." The
nancial crisis of 2007-2009 and its aftermath turned
monetary economics and policymaking on its head and
called into question many of the conventional views held
before the crisis. One of the most popular and enduring
views in all of monetary economics since the 1970s, and
indeed since the 1940s, has been that a nominal interest
rate peg is poor monetary policy, and that attempts to
pursue such a policy would lead to ruin. Yet, post-crisis U.S.
monetary policy could be interpreted as exactly that—an
interest rate peg—and an extreme one at that, since the
policy rate has remained near zero for nearly seven years.
"Rationally, let it be said in a
whisper, experience is certainly
worth more than theory."
Amerigo Vespucci
In this talk, I will summarize some recent academic work
on the idea of a stable interest rate peg and what its
implications may be for current monetary policy choices. I
will argue that a stable interest rate peg is a realistic
theoretical possibility; that it has some mild empirical
support based on a cursory look at the data; and that,
should we nd ourselves in a persistent state of low
nominal interest rates and low in ation, some of our
fundamental assumptions about how U.S. monetary policy
works may have to be altered.
My Current Policy Recommendations
Let me begin by describing brie y my current monetary
policy recommendations. Those of you who have followed
my commentary during 2015 know that I have been an
advocate of ending the Federal Open Market Committee's
(FOMC's) near-zero nominal interest rate policy. My case
has been straightforward. Essentially, I have argued that
while the Committee's goals have been met, the
Committee's policy settings remain as extreme as they
have been at any time since the recession ended in 2009.
With respect to these goals, the current unemployment rate
of 5 percent is statistically indistinguishable from the
Committee's view of the equilibrium long-run rate of
unemployment. In addition, the current year-over-year
in ation rate, while low, re ects an outsized oil price shock
that occurred during 2014. A measure that tries to control
for this effect, the Dallas Fed's trimmed mean in ation rate,
measured year-over-year, is currently running at 1.7
percent, just 30 basis points below the FOMC's in ation
target of 2 percent. By these measures, the Committee's
goals have been met.
On the other hand, the Committee's policy settings remain
far from normal. The policy rate remains near zero, and the
balance sheet is very large relative to its pre-crisis levels. In
the past, the Committee has acted to normalize policy well
before goals have been completely met.
A simple and prudent approach to current policy is to move
the policy settings closer to normal levels now that the
goals of policy have been attained. There is no reason to
continue to experiment with extreme policy settings.
Implicit in my argument is a desire to return to the 19842007 U.S. macroeconomic equilibrium, which involved
relatively good monetary policy, relatively long economic
expansions, and a higher nominal interest rate than we
have today. Part of the nature of that equilibrium was a
monetary policy that was relatively well understood by both
nancial market participants and monetary policymakers.
We gained much experience with the equilibrium over this
time period, and we think we know how it works, in part
because it has been studied extensively from both a
theoretical and empirical perspective.
Rethinking Monetary Policy
Nevertheless, as the topic of this conference is "Rethinking
Monetary Policy," I plan to devote the bulk of my remarks
not to the return to the standard macroeconomic
equilibrium that I recommend, but to the possibility that
such a return is not achieved, despite the Committee's best
efforts to engineer such an outcome for the U.S. economy.
We have, after all, been at the zero lower bound in the U.S.
for seven years. In addition, the FOMC has repeatedly
stressed that any policy rate increase in coming quarters
and years will likely be more gradual than either the 1994
cycle or the 2004-2006 cycle. In short, the FOMC is already
committed to a very low nominal interest rate environment
over the forecast horizon of two to three years. Perhaps
short-term nominal rates will simply be low during this
period, or perhaps the economy will encounter a negative
shock that will propel policy back toward the zero lower
bound.
Our experience is not unique. In Japan, the policy rate has
not been higher than 50 basis points for two decades, and
in the eurozone, the policy rate looks set to remain near
zero at least through September 2016.
The thrust of this talk is to suppose, for the sake of
argument, that the zero interest rate policy (ZIRP) or nearZIRP remains a persistent feature of the U.S. economy.
How should we think about monetary stabilization policy in
such an environment? What sorts of considerations should
be paramount? Should we expect slow growth? Will we
continue to have low in ation, or will in ation rise? Would
we be at more risk of nancial asset price volatility? What
types of concrete policy decisions could be made to cope
with such an environment? Would it require a rethinking of
U.S. monetary policy?
I will provide tentative answers to all of these questions.
But rst, I want to argue that it may indeed be possible to
converge to an equilibrium at the zero lower bound, and
that this situation has some surprising consequences.
Chief among these consequences is that the policy itself
may put downward pressure on in ation in the medium
and long term, rather than upward pressure as
conventionally thought. This is a simple consequence of
the Fisher equation having to hold in concert with
monetary neutrality. I will now turn to developing this point.
Permazero
Most analyses of U.S. monetary policy since the crisis of
2007-2009 have suggested that ZIRP in the U.S. is a
temporary affair, one that was part of an important set of
policy actions designed to mitigate a particularly large
shock to the U.S. economy. But how temporary is it?
We have been at the zero lower bound for nearly seven
years. This is well beyond an ordinary business cycle time.
Normally, we would think of a shock hitting the economy,
with the effects of that shock largely wearing off well
within a seven-year time span. What are the consequences
of spending such a long time with the policy rate at one
value? Arguably, it is an interest rate peg.
In the 1970s and 1980s, the typical reply to this question
was that an interest rate peg was poor policy. Trying to
keep the nominal policy rate unnaturally low for too long a
period would ultimately be in ationary, and indeed, this
was widely viewed as a large part of the problem leading to
global in ation during this era.2 Indeed, during the past six
years I have warned along with many others that the
Committee's ZIRP has put the U.S. economy at
considerable risk of future in ation. In fact, my monetarist
background urges me to continue to make this warning
right now!
In any case, after seven years, one might want to consider
other models. One important possibility is that the 1970s
were an era when U.S. monetary policy was not very
credible with respect to ghting in ation, whereas the
2000s were an era when U.S. monetary policy had already
earned a lot of credibility for keeping in ation low and
stable. One way to interpret this is to say that market
expectations of future in ation today move to stay in line
with the FOMC's desired policy rate instead of becoming
"unanchored" as they did in the 1970s. In particular, this
would mean that a low nominal interest rate peg, far from
being a harbinger of runaway in ation, would instead
dictate medium- and longer-run low in ation outcomes.
This theme is sometimes labelled "neo-Fisherian," because
it emphasizes that the Fisher equation holds in virtually all
modern macroeconomic models. The Fisher equation
states that the nominal interest rate can be decomposed
into a real interest rate component and an expected
in ation component. If we view the real interest rate as
determined by supply and demand conditions in the private
sector, then a permanent nominal interest rate peg would
also pin down the long-run rate of in ation. The Fisher
equation implies, among other things, that the monetary
authority cannot choose the long-run value of the nominal
policy interest rate separately from the long-run value of
in ation.
This Fisher effect is well known and is not likely to be
disputed in macroeconomic circles. However, how long
before this Fisher effect sets in? Over what time period can
the monetary authority maintain an interest rate peg before
the peg itself begins to pull in ation expectations in a
direction consistent with the peg? Is seven years a
su cient length of time? How about 20 years, as in Japan?
Cochrane (2015)
A new paper by Cochrane (2015) provides an interesting
analysis of this issue in the context of the most canonical
of modern macroeconomic models, the linearized threeequation New Keynesian model.3 I will not provide any
details of the model here, but for those who are unfamiliar
with it, I will brie y describe its essential ingredients. The
key friction in the model is that prices are sticky, meaning
that they do not adjust immediately in response to supply
and demand conditions. Households and rms solve
optimization problems taking the friction as given. The
policymaker controls a one-period nominal interest rate,
and through this channel can have temporary effects on
real output and in ation. The Fisher equation holds at all
times. The model can be described by three simple
equations that depend on expectations of future real
output, future in ation and future monetary policy. The
spirit of Cochrane's analysis is to suggest that neoFisherian effects are part of even the most ordinary of
macroeconomic models used to inform current monetary
policy.
Cochrane (2015) uses a solution technique for the model
due to Werning (2012). We can think of the economy as
continuing from the distant past to the distant future. The
policymaker chooses the short-term nominal interest rate
sequence, and, given this sequence, the model traces out
what would happen to the real output gap (x) and in ation
(π).
I use Cochrane's model to trace out the effects on the
economy of the following thought experiment. Suppose the
economy begins with the nominal interest rate equal to 2
percent, a real interest rate equal to 0 percent (for
convenience), and an in ation rate equal to 2 percent. The
Fisher equation holds, as it must, so that in the long run the
policy rate will equal the in ation rate in this example. The
policymaker then lowers the policy rate by 200 basis points
to zero, and leaves it there for a considerable time.
Figure 1 illustrates the effect of such a policy experiment in
Cochrane's (2015) model. The green triangles show the
policy rate, which begins at 200 basis points, but is lowered
to zero at date 0. If the policy move is anticipated, as many
actual policy moves are, then the effects on in ation are
described by the red squares, and the effects on the real
output gap are given by the black circles. If the policy
change is completely unanticipated, then the effects on
in ation are given by the magenta squares, and the effects
on the real output gap are given by the blue circles. In the
case of a "surprise" policy move, nothing happens until the
date of the move, whereupon the in ation and real output
gap variables jump to the path they would have been on,
had the policy change been known in advance. For our
purposes here, it does not matter that much if we focus on
an anticipated or an unanticipated policy change.
Instead, I want to focus on the right hand side of this
picture, after the policy move has occurred. The
policymaker has lowered the policy rate to zero, and in
response, the real output gap has increased.4 This is one
way to gauge the real effects of monetary policy according
to the model: A pure change in the policy rate, with no other
shocks occurring, would temporarily increase output. This
is what the model is designed to do, and if we added more
shocks to the model, the policymaker could use this power
appropriately to smooth real output over time. Smoother
output would be preferred to more volatile output by the
households in the model, and thus the model provides a
theory of monetary stabilization policy.
But now let us look at in ation in response to the policy
change. It falls in response to the policy change, very little
at rst, but more substantially as the zero interest rate
policy continues. After about 2.5 years (10 quarters), at the
far right of the chart, the transitory effects of the policy
change have nearly completely died out. The real output
gap is zero, the policy rate remains at zero, and the in ation
rate has fallen to zero. This can be interpreted as a neoFisherian result: The policy rate is lowered, and after some
transitory dynamics, the in ation rate falls to be consistent
with the new interest rate peg.
Figure 1. The policy rate falls 200 basis points. Adapted
from Cochrane (2015).
It is clear from Figure 1 that, should the policymaker simply
elect to keep the nominal interest rate at zero for a much
longer time, nothing further would happen in this economy.
The black, red and green lines would simply remain at zero.
Cochrane's (2015) analysis, as I have translated it into
Figure 1, yields a very different interpretation of current
events compared to conventional wisdom. Conventional
descriptions of current monetary policy, including my own
description earlier in this very speech, suggest that the
Committee's ZIRP is putting upward pressure on in ation,
perhaps dangerously so. Figure 1 suggests otherwise.
What's going on? The model does have a Phillips curve in
that today's in ation rate does depend in part on today's
real output gap. When the policy rate is lowered, the output
gap is higher than it otherwise would have been, and this
does put upward pressure on in ation in the model.5
However, the model also has a Fisher relation, which
means that as the real output gap returns to normal (that
is, monetary neutrality asserts itself), the in ation rate will
have to fall to be consistent with the new level of the
nominal interest rate. Another aspect is that the
policymaker is viewed as choosing the interest rate
sequence, and in ation follows as dictated by the Fisher
equation. The policymaker cannot set the nominal interest
rate and the in ation target in an inconsistent way.
A few of you may be aware of a closely related analysis by
Benhabib, Schmitt-Grohé and Uribe (2001) that I have
championed in discussing dimensions of monetary policy
since 2007-2009.6 In that analysis the Fisher relation also
plays a prominent role, but the analysis is nonlinear and
global. Benhabib et al. (2001) nd two steady states, one
of which is associated with a low nominal interest rate and
in ation below target. Arguments in this context then
center around which of the two steady states is the stable
one in a reasonable expectation dynamic ("learning"). Often
the argument is that the traditional steady state is the
stable one and therefore the one worthy of the most
attention from policymakers.7 The Cochrane (2015)
analysis is of a linear system, and consequently ideas
about "getting stuck at the wrong steady state" are not
nearly as clear. Rational expectations prevail at all times.8
To illustrate that policymakers can reverse their actions in
the Cochrane (2015) model, Figure 2 illustrates an
alternative policy experiment. This experiment is almost
the same as the one described in Figure 1, except that the
policymaker chooses the nominal policy rate sequence to
remain at zero for seven years before gradually raising the
policy rate back to 2 percent.
Figure 2. A gradual policy rate increase. Adapted from
Cochrane (2015).
The left hand side of Figure 2 simply repeats what is in
Figure 1. The middle portion of Figure 2 shows how the
case where the policy rate remains near zero simply keeps
the in ation rate low and the output gap steady as the
effects of the rst policy move wear off. The gradual policy
rate increase is shown in the right hand portion of Figure 2
via the green triangles. This policy move is portrayed as
being anticipated here, so in ation and the output gap
begin to react before the actual date of liftoff. The rising
rate environment puts downward pressure on the output
gap, reversing the effects of the previous policy rate move.
As before, in ation moves in tandem with the policy rate as
the Fisher equation asserts itself.
Is this what will actually happen in the U.S. economy?
De nitely not, since we are looking here at pure policy
effects with no other shocks added to the model. At best,
Figures 1 and 2 can illustrate the directions that monetary
policy can be expected to push in this particular model, but
a more realistic analysis would include additional shocks,
and monetary policy would have to react appropriately to
those changes in macroeconomic conditions. Still, the key
point is that this canonical model has a clear interpretation
in neo-Fisherian terms, and that this interpretation is hardly
surprising, since the Fisher equation is built into the model.
I have spent a lot of my time with these particular gures
because I think they are interesting and can communicate
to a wide audience in the monetary policymaking
community. But I do want to stress that the New Keynesian
model is just one model in a sea of possibilities. In
addition, it is a model that was designed to describe the
relatively good monetary policy in the U.S. from 1984-2007,
without features that turned out to be quite important
during the 2007-2009 crisis and its aftermath. While I do
not have time to emphasize other more novel work here, let
me just say that there is important recent work in monetary
theory and policy that has tried to explain very low real
rates of return on safe assets along with the implications
for monetary policy. Andolfatto and Williamson (2015), for
instance, think of all consolidated government debt as
having value in conducting transactions. Their model has a
liquidity premium on government debt under some
circumstances, and offers novel interpretations of current
policy dilemmas. Caballero and Farhi (2015) similarly study
safe asset shortages and suggest important ways that our
understanding of the effectiveness of various policies at
the zero lower bound would be affected. These are just
some examples of interesting work going on outside the
relatively narrow New Keynesian framework to try to come
to terms with the reality of the post-crisis macroeconomy.
Empirical Evidence
Figures 1 and 2 suggest that low nominal interest rates and
low in ation may go hand-in-hand, at least over relatively
long horizons in which the policy rate is kept at a constant
level. Over shorter horizons with more policy moves and
more shocks, the correlation may not be very high. Policy
rates have generally been very low, near zero, continuously
in the G-7 economies since the 2007-2009 period.
Consequently, we may be able to look at the data since
2009 to see to what extent neo-Fisherian effects are
exerting themselves in the G-7.9
To get at this issue in just one picture, Figure 3 shows the
centered ve-quarter moving average of the G-7 headline
in ation rate and the average, GDP-weighted, G-7 nominal
policy rate since 2002.
Figure 3. G-7 countries' aggregated in ation and policy
rates. Source: OECD's Main Economic Indicators and
author's calculations. Last observation: September 2015.
In Figure 3, the in ation rate is the solid line on the right
hand scale, and the GDP-weighted nominal policy rate is
the dotted line on the left hand scale. The horizontal green
line is an in ation rate of 2 percent, and the horizontal
black line is an in ation rate of negative 1 percent. The
vertical line in the middle of Figure 3 marks the LehmanAIG event. On the left part of Figure 3, interest rates and
in ation arguably behaved according to traditional
interpretations of New Keynesian theory. On the right half
of Figure 3, the nominal policy rate falls to near zero and
remains there. In ation initially falls across the G-7, but
then impressively returns close to target. In fact, in ation
was above target as of the beginning of 2012, about 2.5
years after the end of the recession in the U.S. Since then,
however, policy rates have remained near zero and in ation
has drifted down, to the point where G-7 in ation is around
zero today.
Conventional wisdom would have suggested that the zero
policy rates in the G-7 were putting upward pressure on
in ation during the nearly four years since January 2012,
but instead, in ation fell. This could be viewed as
consistent with neo-Fisherian effects asserting
themselves. Of course, we have to be cautious about
carrying such an explanation too far. There have been
many other shocks during the past four years, notably a
very large oil price shock beginning in the summer of 2014.
Consequences
Let us suppose for the sake of argument that the G-7
economies will spend still more time at or near the zero
lower bound. This would occur because either liftoff does
not materialize in most or all countries or because
additional negative shocks drive those countries that do
raise their policy rates back to the zero lower bound.
Prudent policymaking suggests that we should at least
entertain this as a realistic possibility for the path of G-7
monetary policy in the coming years. What are the
consequences of remaining in such a state for a long
period of time?10
I can think of six consequences, based on the discussion in
the earlier part of this speech:
First, consider the near-zero policy rate path illustrated on
the right hand side of Figure 1. In this situation, promising
to keep the nominal interest rate sequence at the zero
lower bound simply reinforces the equilibrium and does not
provide accommodation as in the traditional New
Keynesian equilibrium. Nothing happens in response to
such promises. Policymakers would have to come to grips
with such a situation.
Second, in such a situation, in ation remains persistently
below the stated in ation target. The near-zero policy rate
is not putting upward pressure on in ation, but is instead
through the Fisher equation dictating a rate of in ation
lower than the original target. It could be that policymakers
do not intend to return to the original equilibrium—that is,
they may intend to remain with the near-zero policy rate. In
that case, policymakers may wish to lower the in ation
target to remain more consistent with the actual in ation
outcomes.
Third, longer-run economic growth would still be driven by
human capital accumulation and technological progress,
as always, but without the accompanying stabilization
policy as conventionally practiced from 1984-2007. In
principle, the economy would still be expected to grow at a
pace dictated by fundamentals.11
Fourth, the celebrated Friedman rule would arguably be
achieved, so that household and business cash needs are
satiated. In many monetary models this is a desirable state
of affairs.
Fifth, the risk of asset price uctuations may be high. In the
New Keynesian model, the near-zero interest rate policy
with little or no response to incoming shocks is associated
with equilibrium indeterminacy. This means there are many
possible equilibria, all of which are consistent with rational
expectations and market clearing. In a nutshell, a lot of
things can happen. Many of the possible equilibria are
exceptionally volatile. One could interpret this theoretical
situation as consistent with the idea that excessive asset
price volatility is a risk.
Sixth, and nally, the limits on operating monetary policy
through ordinary short-term nominal interest rate
adjustment in this situation would surely continue to re a
search for alternative ways to conduct monetary
stabilization policy. The favored approach during the past
ve years within the G-7 economies has been quantitative
easing, and there would surely be pressure to use this or
related tools.12
Conclusion
During 2015, I have been an advocate of beginning to
normalize the policy rate in the U.S. My arguments have
focused on the idea that the U.S. economy is quite close to
normal today based on an unemployment rate of 5 percent,
which is essentially at the Committee's estimate of the
long-run rate, and in ation net of the 2014 oil price shock
only slightly below the Committee's target. The
Committee's policy settings, in contrast, remain as extreme
as they have ever been since the 2007-2009 crisis. The
policy rate remains near zero, and the Fed's balance sheet
is more than $3.5 trillion larger than it was before the
crisis. Prudence alone suggests that, since the goals of
policy have been met, we should be edging the policy rate
and the balance sheet back toward more normal settings.
Implicit in my argument has been a yearning to return to
the monetary equilibrium of 1984-2007, which is one
around which a great deal of theory and empirical work has
been done. We would be returning to a world in which
monetary policy is better understood, the effects of
policies are more closely calibrated, and private sector
expectations can move and adapt to ordinary adjustments
of the policy rate.
My current policy views have not changed. But in the spirit
of the conference, I have tried to contribute to the topic of
"Rethinking Monetary Policy" by focusing on a situation
where the nominal policy rate and the in ation rate remain
low, either because liftoff does not materialize or because
future negative shocks to the economy force a return to the
zero interest rate policy. I have illustrated by reference to
relatively new research how such a situation could become
permanent. In addition, I have suggested several
consequences of remaining at such an equilibrium over the
long term. It is my hope that my characterizations here will
spur further thinking and research on these important
topics.
Endnotes
1
The views expressed here are my own and do not
necessarily re ect the views of others on the Federal Open
Market Committee. I thank my staff for helpful comments.
[back to text]
2
See, for instance, Sargent and Wallace (1975) for an
argument that an interest rate peg is associated with price
level indeterminacy. [back to text]
3
See Woodford (2003) and Galí (2015). [back to text]
4
The long-run real output gap in this model is not zero
unless the long-run in ation rate is zero, so the initial real
output gap on the left hand side of this picture is
somewhat positive. This is not material to the argument
here, but has been discussed extensively in the New
Keynesian literature. [back to text]
5
The in ation decline is mitigated by the increase in real
activity. [back to text]
6
See Bullard (2010) and Bullard (2015). [back to text]
7
See Eusepi (2007), Evans (2013), and Benhabib, Evans
and Honkapohja (2014). [back to text]
8
García-Schmidt and Woodford (2015) delve into this
question and, in particular, consider departures from
rational expectations. [back to text]
9
For state-of-the-art empirical analysis of the issues
discussed here, see Aruoba and Schorfheide (2015) and
Aruoba, Cuba-Borda and Schorfheide (2014). [back to text]
10
Cochrane (2014) addresses how U.S. monetary policy
might operate in a zero policy rate and large balance sheet
environment. [back to text]
11
Endogenous growth theories that mix long-run growth
prospects with monetary policy practice are rare and of
dubious empirical validity. [back to text]
12
For some recent arguments concerning the future of
monetary policy in a low interest rate environment, see
Haldane (2015). For a theoretical analysis of quantitative
easing at the zero lower bound, see Boel and Waller (2015).
[back to text]
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