How effective lower bound interest rates limit the use of conventional policy tools

Register now

There is no doubt that the U.S. will have low interest rates near zero for at least the next few years, as most Federal Open Market Committee members expect there to be no rate hikes until at least 2022.

There has been a lot of talk around the Fed’s 2% inflation target, which has yet to be met and certainly won’t be anytime soon. If anything, there will be disinflation pressures.

Renuka Diwan, research associate, Sylvain Leduc, executive vice president and director and Thomas M. Mertens, vice president, members of the economic research department of the Federal Reserve Bank of San Francisco, released an economic letter about average-inflation targeting and the effective lower bound.

They concluded the “effective lower bound near zero limits the use of conventional policy tools in a low interest rate environment” and hence policymakers’ ability to mitigate the negative effects of recessions on employment and inflation.

Renuka Diwan, a research associate in the economic research department of the Federal Reserve Bank of San Francisco.

“More frequent encounters with the effective lower bound in the future may thus lead inflation and inflation expectations to settle below 2% over time,” they wrote. “Average-inflation targeting is one approach policymakers could use to help address these challenges. Taking into account previous periods of below-target inflation, average-inflation targeting overshoots to bring the average rate back to target over time. If the public perceives it to be credible, average-inflation targeting can help solidify inflation expectations at the 2% inflation target by providing a better inflation anchor and thus maintain space for potential interest rate cuts. “It importantly can help lessen the constraint from the effective lower bound in recessions by inducing policymakers to overshoot the inflation target and provide more accommodation in the future.”

They also noted that personal consumption expenditures, has “stayed below” the FOMC’s target for “most” of the past decade.

Sylvain Leduc, executive vice president and director of the economic research department at the Federal Reserve Bank of San Francisco.

“Both inflation and inflation compensation have persistently stayed below the 2% target over the past 10 years. This evidence is consistent with alternative survey based measures of inflation expectations,” they said. “One potential driver of these developments over past decades has been the decline in the natural real rate of interest, the rate consistent with maximum employment and price stability, which has contributed to lower nominal interest rates and because nominal rates cannot go below the effective lower bound, essentially zero, policymakers have less room to cut interest rates to mitigate recessions."

They added that “persistent” risk of interest rates falling to the lower bound can “erode” inflation expectations.

“If households, businesses, and investors anticipate such conditions happening more frequently, they may expect future inflation to be lower than the official target,” they wrote. “Lower inflation expectations, in turn, put further downward pressure on inflation and restrict economic activity.”

Employment trends index

Thomas M. Mertens, vice president, economic research department of the Federal Reserve Bank of San Francisco.

The ETI nudged up to 50.89 in July from 49.46, the Conference Board said on Monday.

This marks the third month in a row of increases, although year-over-over, the index is down by 53.8%.

“Despite increasing again, the ETI’s July results mark a small improvement compared to the gains made in May and June, while the slowing momentum likely resulted from the diminishing impact of the reopening of the economy,” said Gad Levanon, head of the Conference Board Labor Markets Institute. “This stark deceleration represents a preview of what’s to come: Over the next several months, job growth will significantly put on the brakes, likely causing the national unemployment rate to remain in double-digit territory. Less generous government stimulus will dampen consumer spending. In addition, more waves of downsizing and bankruptcies will spur widespread layoffs — and thus further constrain the expansion of the US workforce.”

Job openings and labor turnover survey
Job openings increased to 5.9 million as of June 30, while hires shrunk to 6.7 million, according to the U.S. Bureau of Labor Statistics.

Job losses rose to 4.8 million in total. The quits rate increase 1.9%, while the layoffs and discharges was steady at 1.4%.

For reprint and licensing requests for this article, click here.
Economic indicators Federal Reserve Bank of San Francisco Interest rates Inflation FOMC