Low interest rates increase the chance of hitting zero lower bound rates, forcing the Federal Reserve to use nontraditional monetary policy tools, could extend recessions and hold down inflation, Federal Reserve Bank of Cleveland President Loretta Mester said Friday.

With estimates of the equilibrium real fed funds rate, or r-star, lower than its historical norm, “there will be less room for monetary policymakers to cushion against a negative economic shock than in the past,” Mester said in a panel discussion in Philadelphia, according to text released by the Fed. “Said differently, the policy rate will have a higher chance of hitting the zero lower bound, necessitating the use of nontraditional monetary policy tools more often.”

Federal Reserve Bank of Cleveland President and CEO Loretta J. Mester.
Federal Reserve Bank of Cleveland President and CEO Loretta J. Mester. Bloomberg News

Since nontraditional tools don’t work as well as changing interest rate targets, “the potential is for longer recessions and longer bouts of low inflation.”

Mester discussed four alternative monetary policy frameworks that could be considered by the fed.

First, the Fed could raise its inflation target to 4%, which “would offset a lower equilibrium real rate and so the nominal rate would be less likely to hit the zero lower bound for any given negative shock,” she said.

While familiarity, since it’s similar to the current framework, is a plus, “the transition could be difficult,” Mester said. “The benefits of the higher target come only if the public views the increase as permanent so that inflation expectations rise to the new higher target. But inflation expectations are reasonably well anchored at 2 percent, so raising expectations would not necessarily be easy to do.”

This plan could also increase “inflation volatility and with higher inflation risk premia, neither of which is desirable.”

Of course, it’s not clear that a 4% inflation target “be viewed as consistent with the Fed’s mandate of price stability.” A smaller increase in the inflation “would add only modest room for keeping the policy rate from the zero lower bound.”

Finally, she said, the costs of higher inflation would have to be weighed against the benefits of avoiding zero lower bound.

Other alternatives discussed included targeting a level of prices rather than the growth rate; targeting nominal GDP rather than its growth rate.

Both “have the benefit of building in some forward commitment,” but neither comes with much practical use. Also, when levels are targeted, “the starting point matters, and these frameworks are complicated by other measurement issues as well.”

Lastly, Mester suggested a "temporary price-level-targeting framework,” under which inflation would be targeted “in normal times,” and at “zero lower bound, they would begin targeting the price level from that starting point.”

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