from the Minneapolis Fed
A recent Minneapolis Fed study offers insight into one of the reasons for the slow USA recovery – the zero rate policy of the Federal Reserve.
The year 2008 will long be remembered in the macroeconomics literature. This is so not only because of the massive shock that hit global ﬁnancial markets, particularly the bankruptcy of Lehman Brothers and the collapse of the interbank market that immediately followed, but also because of the unusual and extraordinary response to the crisis, emanating from all major central banks. The reaction of the Federal Reserve is a clear example: it doubled its balance sheet in just three months—from $800 billion on September 1 to $1.6 trillion by December 1. Then the Fed kept on increasing its balance sheet to reach around $3 trillion by the end of 2012. Similar measures were taken by the European Central Bank and other central banks in developed economies. Most macroeconomists would probably agree that the 2008-2013 period is, from the point of view of US macroeconomic theory and policy, among the most dramatic in the past 100 years, perhaps second only to the Great Depression.
An overview of the study:
The model provides an interpretation of the events following 2009 that is diﬀerent from the one provided by a branch of the literature that, using New Keynesian models, places a strong emphasis on the interaction between the zero bound constraint on nominal interest rates and price rigidities.8 This is also the dominant view of monetary policy at major central banks, including the Fed. According to this view, a shock— often associated with a shock to the eﬃciency of intermediation9—drove the natural real interest rate to negative values. The optimal monetary policy in those models is to set the nominal interest rate equal to the natural real interest rate. However, because of the zero bound, that is not possible. But it is optimal, unambiguously, to keep the nominal interest rate at the zero bound, as the Fed has been doing for over four years now. Furthermore, these models imply that it is unambiguously optimal to maintain the nominal interest rate at zero even after the negative shock reverts. This policy implication, called “forward guidance,” has dominated the policy decisions in the United States since 2008 and remains the conceptual framework that justiﬁes the “exit strategy.”
On the contrary, the model we study stresses a diﬀerent and novel trade-oﬀ between ameliorating the initial recession and delaying the recovery. When the central bank chooses a lower inﬂation target, the liquidity trap lasts longer, the real interest rate is constrained to be higher, and therefore there is less reallocation of capital toward less productive, and previously inactive, entrepreneurs. The counterpart of the milder drop in TFP is a drop in investment due to the crowding out, leading to a substantial and persistent decline in the stock of capital and a slower recovery
The study concludes:
A contraction in credit due to a tightening of collateral constraints leads to a recession and a drop in the return of safe assets. In a monetary economy, the nominal return on safe assets cannot be negative, so the negative of the rate of inﬂation is a lower bound on its real return. We showed that if the contraction in credit is large enough, then this constraint becomes binding and the economy enters a liquidity trap. In this case, a deﬂation occurs if policy is passive. This deﬂation may interact with collateral constraints, creating debt deﬂation and worsening the recession if debt obligations are in nominal terms. In addition, it creates a large drop in employment if wages are sticky.
We characterize a policy that avoids that costly deﬂation. That policy resembles the one followed by the Federal Reserve as a reaction to the 2008 crisis and is in line with Friedman and Schwartz’s explanation of the severity of the Great Depression.
The policies that avoid the deﬂation involve a large increase in money or bonds, which are perfect substitutes at the zero bound. These policies do stabilize prices and output. There is a side eﬀect of these policies, though: they generate slow recovery. We argue that many of the features of the model capture the characteristics of the last ﬁnancial crisis that hit the United States starting in 2008 and the one that hit Japan in the early 1990s.
The interpretation of the crisis provided by the model in this paper is in contrast to the dominant view in most central banks and is supported by a literature that emphasizes price frictions. According to that literature, it is unambiguously optimal to maintain the economy at the zero bound even after the shock that drove real interest rates to negative values reverts. The model of this paper implies that avoiding the zero bound or not implies nontrivial trade-oﬀs: ameliorating the drop in output at the cost of a slower recovery. The policy trade-oﬀs are even more subtle when the heterogeneous eﬀects across agents are taken into account.
Our model rationalizes the notion that the inﬂation determination mechanisms diﬀer substantially when the policy authority decides to be at the zero bound. Away from the zero bound, it depends on standard monetary mechanisms. But at the zero bound, it is total outside liabilities that matter: inﬂation can be controlled only by managing the real interest rate so it does not become too negative.