Crafting monetary policy for the 21st century economy

Crafting monetary policy for the 21st century economy
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In the 21st century, central banks face a challenge that few economists predicted: how to conduct monetary policy when interest rates fall to zero. In early June, the Federal Reserve held a conference in Chicago called “Fed Listens” to look at ideas for reforming monetary policy, with a special focus on the zero-rate problem. 

While economists have long understood that zero interest rates create problems for monetary policy, this situation had not occurred since the Great Depression of the 1930s, before unexpectedly re-occurring during the Great Recession and its aftermath. 

Cutting interest rates has been the Fed’s most widely utilized method for providing stimulus during recessions. Because holding assets in cash always pays zero interest, however, it has traditionally been assumed that the Fed was unable to reduce market interest rates significantly below zero.


Admittedly, some countries have recently achieved very slightly negative interest rates, taking advantage of the fact that financial institutions are uncomfortable holding large sums of cash and will therefore pay a small price for the privilege of storing funds in safe government bonds. But the Fed seems uninterested in adopting that controversial policy. 

Once interest rates hit zero during the deep recession of 2009, the Fed began experimenting with other approaches, such as quantitative easing (QE) — buying up assets to inject money into the economy. This policy had some success in promoting recovery, but not as much as the Fed would have liked. Thus, the search for more options began. 

Some economists have suggested raising the inflation target from 2 percent to 3 or 4 percent. The motivation is to keep interest rates above zero, since higher inflation rates generally lead to higher market interest rates, as we saw in the 1970s. However, the Fed views that idea as inconsistent with its congressional mandate of stable prices and high employment.

Now, the Fed seems to be considering less-controversial policies that would deliver some of the same benefits when we need them the most.

One option discussed at the conference was “price-level targeting” — holding the long-run inflation target at 2 percent per year and then promising to return to that trend line whenever there are temporary undershoots or overshoots.


Thus, a year of 3-percent inflation might be followed by a year of 1-percent, and vice versa. The goal is to make longer-run changes in the price level predictable.

This policy would be especially helpful when the Fed is unable to cut interest rates below zero, also known as the “zero-bound problem.” This problem tends to occur during recessions, when interest rates fall to zero and inflation also declines.

With inflation temporarily below target, price-level targeting would allow the Fed to commit to the aforementioned period of offsetting, above-normal inflation, which in turn makes a more aggressive QE policy more acceptable during recessions.

In normal circumstances, the Fed loses credibility with financial markets when a policy like QE overshoots the 2-percent inflation target, and this reduces the effectiveness of monetary policy. With price-level targeting, market participants would understand that during a recession, below-target inflation today will be followed by somewhat-higher-than-normal inflation in the future.

Higher inflation expectations create a more expansionary monetary policy by lowering real interest rates. If nominal interest rates are at 2 percent and the expected inflation rate rises to 3 percent, then the real cost of the loan falls to -1 percent.

Thus, when rates are stuck at low levels, the expectation of higher prices (and home values) in the future makes firms and homebuyers more willing to borrow money today. 

You might be wondering if the Fed could use elements of this stimulative policy without formally adopting price-level targeting. Perhaps, but Fed officials prefer to have a clear and transparent policy target that is understandable to the public. A rules-based approach makes policy more credible, which helps to ensure it has the intended impact. 

The conference also considered a closely related option called “average inflation targeting,” which would target the average inflation rate over an extensive period of time, say 5-10 years.

Many Fed officials prefer this option because it sounds closer to the existing policy than does price-level targeting. Both allow for the make-up of inflation undershoots, and thus have some of the same advantages. 

Look for an intensive discussion of average inflation targeting early next year when the Fed considers revising its policy strategy.

Scott Sumner is an emeritus professor of economics at Bentley University and the Ralph G. Hawtrey chair of Monetary Policy at the Mercatus Center at George Mason University.