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posted on 11 November 2017

Fed's Effective Lower Bound Constraint On Monetary Policy Created Uncertainty

from the Dallas Fed

-- this post authored by Michael Plante, Alexander W. Richter and Nathaniel A. Throckmorton

Uncertainty about the economy increased when the Fed reduced the federal funds rate to its effective lower bound because the constraint restricted the Fed’s ability to stabilize the economy. As a result, a much stronger negative relationship between uncertainty and economic activity emerged during and shortly after the Great Recession.

The financial crisis and subsequent recession compelled the Fed to take unprecedented action in December 2008. Policymakers reduced the benchmark federal funds rate to a range of 0 to 25 basis points (0.25 percentage points) - the effective lower bound (ELB).

Reaching the ELB was important because the federal funds rate is the primary tool the Fed uses to implement monetary policy, and pushing the rate so low constrained the central bank’s ability to stabilize the economy and meet its goal of full employment and price stability.

Economists widely believe the ELB can have significant negative implications for economic activity. However, the ELB can also create uncertainty about the future economy. Since the ELB prevents the Fed from responding to unexpected negative economic events with its traditional policy tool, those events more severely affect the economy than in normal times. Uncertainty about the economy rises because people have a more difficult time predicting future outcomes.

[click on image below to continue reading]

Source

https://www.dallasfed.org/~/media/documents/research/ eclett/2017/el1711.pdf

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