Monetary Policymaking in Today’s Environment: Finding "Policy Space" in a Low-Rate World
April 15, 2019
Cornelson Distinguished Lecture
Boston Fed President Eric Rosengren spoke Monday at Davidson College in North Carolina.
Key takeaways from Rosengren’s remarks:
- The economy is doing well, but the inflation rate remains below the Fed’s 2 percent target.
- Below-target inflation and a low interest rate environment limit policymakers’ “room to maneuver” in the event of an economic downturn.
- A more firmly ingrained inflation target would help – for example, the Fed could aim to achieve its inflation target on average over the economic cycle.
- In addition to the limited room for short-term rate cuts, an alternative tool – influencing long-term rates – is also constrained.
- With the economy doing well, it’s a good time to consider if changes to the Fed’s policy framework could provide “policy space” for action in a hypothetical future downturn.
In hindsight, Rosengren said, the Fed’s 2 percent target has acted more like a ceiling than a symmetric target. Still, below-target inflation factors into current policy: “One reason for the policy committee’s decision to be patient in determining future rate adjustments, despite tight labor markets, is waiting to see more convincing evidence that inflation will achieve and sustain the 2 percent inflation target.”
Rosengren said the below-target inflation and low interest rate environment would give monetary policy-makers little space to maneuver in a hypothetical next recession. In each of the last three downturns, the Fed has lowered short-term rates by more than 5 percentage points. Today, rates are well below that level, which implies policymakers today “now have much less latitude to use short-term rates to counter a recession.”
Rosengren said there are various ways the inflation target could be more firmly ingrained. One would be for the Fed to “aim to achieve its inflation target on average over the economic cycle. This would allow the inflation rate to move within a rangecentered around its target.” The Fed could offset an undershoot of the inflation target during recessions by overshooting the target during recoveries. By keeping inflation expectations stable and creating space for policy to act, in sum, inflation averaging would “make the extent of recessions less severe.”
Policymakers aren’t limited to cutting short-term rates as their only policy tool: Central banks can purchase longer-term assets to reduce their rates, using the central bank’s balance sheet. But Rosengren noted that long-term yields are already close to zero in Germany and Japan. The U.S. 10-year Treasury rate provides policymakers with more space to act, but it’s still low by historical standards. “So this other monetary policy tool – influencing long-term rates – would also have limited power to respond to a hypothetical economic downturn,” Rosengren said. He added, “if we want to have more capacity to lower long-term rates in recessions without increasing the size of the Fed’s balance sheet, policymakers may wish to hold more short-term securities in good times.”
“Now is a good time to reflect on the Federal Reserve’s monetary policy framework,” Rosengren concluded, referring to a process that is underway. “Both the U.S. and many developed economies are likely to be challenged by the implications of a low interest rate environment for our ability to offset recessions.”
Rosengren was speaking at Davidson College in Davidson, North Carolina, delivering the 33rd Cornelson Distinguished Lecture sponsored by the economics department. His talk was streamed live at https://davidson.edu/livestream.