1. Denial
I think it is fair to say that, for many who have been involved in central banking over the past two or three decades, it is difficult to think of Japan and the United States in the same game, as Figure 1 suggests. For many, the situation in Japan since the 1990s has been a curiosum, an odd outcome that might be chalked up to particularly Byzantine Japanese politics, the lack of an inflation target for the Bank of Japan (BOJ), a certain lack of political independence for the BOJ, or some other factor specific to the Land of the Rising Sun. The idea that U.S. policymakers should worry about the nonlinearity of the Taylor-type rule and its implications is sometimes viewed as an amusing bit of theory without real ramifications.
2. Stability
There is another version of the denial view that is somewhat less extreme but nevertheless still a form of denial in the end. It is a view that I have been associated with in my own research. In this view, one accepts the zero bound on nominal interest rates and the other details of the analysis by Benhabib, Schmitt-Grohé, and Uribe. One accepts that there are two steady states. How – ever, the steady states have stability properties associated with them in a fully dynamic analysis, and the argument is that the targeted steady state is the stable one, while the unintended, low nominal interest rate steady state is unstable. Therefore, according to this argument, one should expect to observe the economy in the neighborhood of the targeted steady state and need not worry about the unintended, low nominal interest rate steady state.
3. The FOMC in 2003
In Figure 1, a set of data points is circled. These data are labeled “2003-2004” and are associated with a policy rate at 1.0 percent and the inflation rate between 1.0 and 1.5 percent. This episode was the last time the FOMC worried about a possible bout of deflation. While core inflation did move to a low level during this period—not quite as low as the current level—inflation moved higher later and interest rates were increased. This episode surely provides comfort for those who think the Japanese-style outcome is unlikely. It suggests that the economy will ultimately return to the neighborhood of the targeted steady state, perhaps even indicating that the stability story is the right one after all. The 2003 experience did not involve a near-zero policy rate, however.
4. Discontinuity
If the problem is the existence of a second, unintended steady state—and this is partly caused
by the choice of a policy rule that is controlled by policymakers—why not just choose a different policy rule? This can, in fact, be done and was discussed by Benhabib, Schmitt-Grohé, and Uribe in their original paper. Furthermore, some parts of the current policy discussion have exactly this flavor.
….Of course, this policy looks unusual and perhaps few would advocate it, but again we are trying to avoid all those circles down there in the southwest portion of the diagram. The discontinuouspolicy has the great advantage that it is a very simple way to ensure that the unintended, low nominal interest rate steady state no longer exists. The only point in the diagram where the Fisher relation and the policy rule can be in harmony is the targeted equilibrium. This would remove the unintended steady state as a focal point for the economy.
5. Traditional Policy
According to the Bank of England,15 for 314 years the policy rate was never allowed to fall below 2.0 percent. During more than three centuries the economy was subject to large shocks, wars, financial crises, and the Great Depression— yet 2.0 percent was the policy rate floor until very recently. A version of this policy is displayed in Figure 5. This policy rule does not eliminate the unintended steady state; it simply moves it to be associated with a higher level of inflation. In the figure, this point occurs at an interest rate of 2.0 percent and an inflation rate of 1.5 percent (the center arrow in the figure). This policy seems very reasonable in some ways. To the extent that one of the main purposes of the interest rate policy is to keep inflation low and stable, this policy creates two steady states, but the policymaker may be more or less indifferent between the two outcomes. Then one has to worry much less about the possibility of becoming permanently trapped in an unintended, deflationary steady state. This policy prevents the onset of interest rates that are “too low.”
6. Fiscal Intervention Given the Situation in Europe
In the academic literature following the 2001 publication of the perils paper, some attempt was made to provide policy advice on how to avoid the unintended steady state of Figure 1.17 This advice was given in the context of trying to preserve the desirable qualities of the Taylor-type interest rate rule in the neighborhood of the targeted steady state. That is, even though interest rate rules are the problem here, the advice is given in the context of those rules—as opposed to simply abandoning them altogether.
7. Quantitative Easing
The quantitative easing policy undertaken by the FOMC in 2009 has generally been regarded as successful in the sense that longer-term interest rates fell following the announcement and implementation of the program.20 Similar assessments apply to the Bank of England’s quantitative easing policy. For the United Kingdom in particular, both expected inflation and actual inflation have remained higher to date, and for that reason the United Kingdom seems less threatened by a deflationary trap. The U.K. quantitative easing program has a more state-contingent character for rates to bottom out at a level somewhat higher than zero, as the traditional policy rule does. Of course, a policy rule like the one depicted in Figure 5 does not allow as much policy accommodation in the face of shocks to the economy at the margin. But is it worth risking a “lost decade” to get the extra bit of accommodation?
Click Here To Read: Japan in the US? Seven Faces of “The Peril”