During the Great Moderation period from the mid-1980s to 2007, economists grew confident that central banks could stabilise economies by raising and lowering short-term interest rates. A startling development during the Great Recession of 2008-2009 was that policy rates in advanced economies fell to near zero (Blanchard et al. 2016), yet that was not sufficient stimulus to promote strong recoveries. Rates have stayed near zero in many countries, suggesting a liquidity trap: further stimulus is needed, but central banks’ traditional tool of policy rate cuts is not available.
2016 Geneva Report on the World Economy,
we examine the liquidity trap, or lower bound on interest rates (Ball et al. 2016). We first document the severity of the problem – how it has constrained monetary policy since 2008, and how it is likely to constrain policy in the future – and then discuss how central bank policymakers can respond. Contrary to the common view that central banks are “out of ammunition” when policy rates fall to zero, we believe they can provide stimulus, notably by pushing rates negative and through aggressive forms of quantitative easing (QE). Looking further ahead, policymakers can greatly reduce the danger of the lower bound by a modest increase in their inflation targets.
The Danger of the Lower Bound
There is little doubt that the lower bound on interest rates has constrained monetary policy since 2008. For the US, for example, a pre-crisis Taylor rule dictates a federal funds rate of -5% or -6% in 2009. The actual rate never fell below zero. Based on a simple macroeconomic model, we estimate that US unemployment rates from 2009 through 2015 averaged more than a percentage point higher than they would have if there were no lower bound on interest rates. Unemployment would have been higher still if not for the Federal Reserve’s policy of quantitative easing (discussed below).
A crisis of that magnitude is not necessary for the lower bound to constrain monetary policy, however. Our report emphasises that, going forward, even modest economic downturns are likely to push interest rates to zero. This prospect is the result of two factors. One is the low inflation targets chosen by central banks, typically close to 2%. The second is the apparent fall in the neutral real interest rate over the last two decades, to current estimates of about 1% or even lower. Together, these numbers imply that the steady state nominal interest rate is 2 + 1 = 3%. Starting from this level, a central bank can reduce its policy rate only 300 basis points before hitting zero – not enough stimulus to offset a moderate-size shock to the economy.
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