Although conventional interest rate policy is constrained by the fact that nominal interest rates cannot fall below zero, the second arrow in the Federal Reserve's quiver--the provision of liquidity--remains effective. Indeed, there are several means by which the Fed could influence financial conditions through the use of its balance sheet, beyond expanding our lending to financial institutions. First, the Fed could purchase longer-term Treasury or agency securities on the open market in substantial quantities. This approach might influence the yields on these securities, thus helping to spur aggregate demand. Indeed, last week the Fed announced plans to purchase up to $100 billion in GSE debt and up to $500 billion in GSE mortgage-backed securities over the next few quarters. It is encouraging that the announcement of that action was met by a fall in mortgage interest rates.

Regarding interest rate policy, although further reductions from the current federal funds rate target of 1 percent are certainly feasible, at this point the scope for using conventional interest rate policies to support the economy is obviously limited.  Indeed, the actual federal funds rate has been trading consistently below the Committee's 1 percent target in recent weeks, reflecting the large quantity of reserves that our lending activities have put into the system. In principle, our ability to pay interest on excess reserves at a rate equal to the funds rate target, as we have been doing, should keep the actual rate near the target, because banks should have no incentive to lend overnight funds at a rate lower than what they can receive from the Federal Reserve. In practice, however, several factors have served to depress the market rate below the target. One such factor is the presence in the market of large suppliers of funds, notably the government-sponsored enterprises (GSEs) Fannie Mae and Freddie Mac, which are not eligible to receive interest on reserves and are thus willing to lend overnight federal funds at rates below the target.¹ We will continue to explore ways to keep the effective federal funds rate closer to the target.

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1.  Banks have an incentive to borrow from the GSEs and then redeposit the funds at the Federal Reserve; as a result, banks earn a sure profit equal to the difference between the rate they pay the GSEs and the rate they receive on excess reserves. However, thus far, this type of arbitrage has not been occurring on a sufficient scale, perhaps because banks have not yet fully adjusted their reserve-management practices to take advantage of this opportunity.

Asked whether there would be FOMC concern about running out of room to cut rates or about running into the "zero bound" on rates, Stern replied, "Personally, I think the bigger issue is that when you get short-term rates that low, for some institutions like money market funds it's very hard for them to be in the business, because there's no room between the cost of their funds and the return on their assets.  So there are some structural or institutional issues that might come into play, but beyond that I'm not sure I see much."

"If you think that the economic outlook requires a lower target, then I think that you should implement it, in my judgment, but with the caveat that I just gave: bearing in mind that there may be institutional reasons why you may prefer to avoid reducing rates," Stern said.

"So you have to weigh those things," he said. "Otherwise, I would say that if the outlook seems to require it then you should do it."

Asked whether the doubling in size of the balance sheet represents "quantitative easing," Stern said "I don't think that's a bad statement.   I think the world is a little more complicated than that, but I don't think that's a bad statement." 

Federal Reserve Bank of San Francisco President Janet Yellen said the central bank may cut the benchmark interest rate close to zero percent from the current 1 percent level should the economy remain weak.

``We would do it because we are concerned about weakness in the economy,'' Yellen said today after a speech, responding to an audience question about the impact on the economy should the Fed reduce the main rate to as low as zero. ``I think we could, potentially, go a little bit lower than'' 1 percent, she said in Berkeley, California.

From audience Q&A, as reported by Bloomberg News

Clearly you can't get interest rates below zero ... but we actually have interest rates now at 2-1/4 percent and clearly there is some room to lower them if it's needed.

... Furthermore, we are continually looking at steps to make the markets function better and I think we've been quite creative in terms of the steps we've taken so far, but in fact we will continue to look at the steps that we can take to in fact make the functioning of the financial markets get back to a more normal situation

From Q&A as reported by Reuters

What do we mean by price stability?  A widely cited definition is that the inflation rate is sufficiently low so that households and businesses do not need to take inflation into account in making everyday decisions.³  Broadly speaking, I believe this definition of price stability is a reasonable one, and in practice, central banks around the world have chosen average levels of inflation between 0 and 3 percent as consistent with this criterion. However, this range can be narrowed a bit further by considering the implications of economic theory and empirical evidence about the average inflation rate that produces the best economic outcomes...

In contrast, given shocks like those seen over the past several decades, an average inflation rate higher than about 1 percent substantially reduces the frequency with which the economy hits the zero lower bound. An inflation objective of about 2 percent implies that monetary policy is rarely constrained by the zero lower bound and thereby minimizes the adverse consequences for macroeconomic stability.

The last item on my list of limitations was that simple rules do not take account of risk-management considerations.  As shown in Figure 2A, the core CPI inflation rate for 2003 was falling toward 1 percent.  The real-time reading of the core PCE inflation rate (not shown) was on average even lower than the comparable CPI figure.  Given these rates, the possibility of deflation could not be ruled out.  We had carefully analyzed the Japanese experience of the early 1990s; our conclusion was that aggressively moving against the risk of deflation would pay dividends by reducing the odds on needing to deal with the zero bound on nominal interest rates should the economy be hit with another negative shock.  This factor is not captured by simple policy rules.

Of course, gradualism and model averaging may not be appropriate in all circumstances.  For example, it may be necessary for monetary policy to respond to what might be called "tail events," along the lines suggested by recent work on "robust control."  To simplify greatly, this approach often amounts to choosing policy settings to minimize the maximum possible loss across different models of the economy, in contrast to the standard Bayesian approach, which (loosely speaking) seeks to minimize the average loss across models.  Much of the research on robust control has been a bit technical and esoteric.  But the notion that policymakers may at times base policy settings on especially pernicious risks has an important ring of truth. 

For example, in 2003 the FOMC noted that a continued fall in inflation would be unwelcome largely because such an eventuality might potentially lead to persistently weak real activity with interest rates stuck at zero.  Partly in response, the FOMC reduced the federal funds rate to an unusually low level and kept it there for an extended period, in a manner that perhaps would not have occurred in the absence of concerns about the "worst case" effects of deflation.  This type of risk management--in which the central bank takes out some insurance against a bad but improbable event--has been an aspect of policymaking for some time and does seem to respond to extreme risks in a way reminiscent of the literature on robust control.

Before the 1980s, research papers, economic commentary, and textbooks here and abroad were full of discussions of the causes and consequences of high inflation and of the political difficulty of bringing it under control. It looked then like inflation had become a more or less permanent feature of the economic landscape. Concepts associated with deflation such as liquidity traps and the zero bound on nominal interest rates had, for practical purposes, disappeared from economic thought.

In fact, central banks have a number of other means at their disposal to stimulate spending should nominal interest rates hit the zero bound. A central bank can increase the supply of reserves to the financial system through regular open-market operations even after short-term nominal interest rates have hit zero. Such actions may demonstrate a resolve by the central bank to keep short-term interest rates at zero for a prolonged period of time, with the intention of raising inflation expectations and lowering real interest rates.

Arguably, a more effective approach to combating deflation--and a relatively straightforward extension of current operating procedures--would be for a central bank to stimulate aggregate demand by lowering interest rates further out along the maturity spectrum. A central bank could expand its open market purchases of longer-term government securities, in sizable quantities if necessary, to drive term premiums lower. Of course, because long-term interest rates incorporate term premiums as well as discounted expectations of future short-term interest rates, the success of operations focused on influencing parts of the yield curve would be bolstered by a credible promise to move the short-term policy rate along a trajectory consistent with the targeted longer-term yields.

Alternatively, as economists have long recognized, a central bank could influence expectations of future short-term interest rates directly by committing to keeping the policy interest rate at zero for a specified and relatively long period of time or until some intermediate macroeconomic target--such as the termination of declining prices--was achieved. As a practical matter and to underscore its commitment to boosting aggregate demand, a central bank could write options that would, for a pre-specified time, make its raising interest rates costly, or it could operate in the forward interest rate market.

What I have in mind is that the Bank of Japan would announce its intention to restore the price level (as measured by some standard index of prices, such as the consumer price index excluding fresh food) to the value it would have reached if, instead of the deflation of the past five years, a moderate inflation of, say, 1 percent per year had occurred.

...

Reflation--that is, a period of inflation above the long-run preferred rate in order to restore the earlier price level--proved highly beneficial following the deflations of the 1930s in both Japan and the United States. Finance Minister Korekiyo Takahashi brilliantly rescued Japan from the Great Depression through reflationary policies in the early 1930s, while President Franklin D. Roosevelt's reflationary monetary and banking policies did the same for the United States in 1933 and subsequent years.

...

Eggertsson and Woodford (2003) have advanced a second argument for a price-level target for Japan in an important recent paper on monetary policy at the zero bound. These authors point out (as have many others) that, when nominal interest rates are at or near zero, the central bank can lower the real rate of interest only by creating expectations of inflation on the part of the public. Eggertsson and Woodford argue that a publicly announced price-level target of the type just described is more conducive to raising near-term inflation expectations than is an inflation target.

Although the U.S. economy has largely escaped any deflation since World War II, there are some well-founded reasons to presume that deflation is more of a threat to economic growth than is inflation. For one, the lower bound on nominal interest rates at zero threatens ever-rising real rates if deflation intensifies. A related consequence is that even if debtors are able to refinance loans at zero nominal interest rates, they may still face high and rising real rates that cause their balance sheets to deteriorate.

Another concern about deflation resides in labor markets. Some studies have suggested that nominal wages do not easily adjust downward. If lower price inflation is accompanied by lower average wage inflation, then the prevalence of nominal wages being constrained from falling could increase as price inflation moves toward or below zero. In these circumstances, the effective clearing of labor markets would be inhibited, with the consequence being higher rates of unemployment.

Taken together, these considerations suggest that deflation could well be more damaging than inflation to economic growth. While this asymmetry should not be overlooked, several factors limit its significance. In particular, more rapid advances in productivity can make this asymmetry less severe. Fast growth of productivity, by buoying expectations of future advances of wages and earnings and thus aggregate demand, enables real interest rates to be higher than would otherwise be the case without restricting economic growth. Moreover, to the extent that more-rapid growth of productivity shows through to faster gains in nominal wages, there will be fewer instances in which nominal wages will be pressured to fall.

One also should not overstate the difficulties posed for monetary policy by the zero bound on interest rates and nominal wage inflexibility even in the absence of faster productivity growth. The expansion of the monetary base can proceed even if overnight rates are driven to their zero lower bound. The Federal Reserve has authority to purchase Treasury securities of any maturity and indeed already purchases such securities as part of its procedures to keep the overnight rate at its desired level. This authority could be used to lower interest rates at longer maturities. Such actions have precedent: Between 1942 and 1951, the Federal Reserve put a ceiling on longer-term Treasury yields at 2-1/2 percent. With respect to potential difficulties in labor markets, results from research remain ambiguous on the extent and persistence of downward rigidity in nominal compensation.

Clearly, it would be desirable to avoid deflation. But if deflation were to develop, options for an aggressive monetary policy response are available.

While both respecifications [suggested by Reifschneider and Williams] improve the performance of the economy during periods subject to the zero nominal bound, they raise a question about the credibility of the commitment implied by the rule. In particular, the effectiveness of such a commitment hinges directly on the ability of the central bank's promise of future actions (perhaps several years into the future) to influence the public's expectations today. In such a case, transparency may offer an important benefit. In particular, if workers, firms, and investors can be convinced through public statements that an unusual situation calls for unusual action, the central bank's ability to affect expectations about its future policy--when the promised future policy is different from its normal conduct--may be enhanced.

Many potential inflation targeters ask, "Why not zero?"...[One] reason for shooting at a rate of inflation slightly above zero is known as the zero bound problem. If a country's real interest rates are close to zero and its inflation rate is close to zero, its nominal interest rates will also be close to zero. Since costs of holding cash are minimal, a central bank cannot push nominal interest rates much below zero. This means that countries that target for zero inflation could get in the bind of being unable to ease monetary policy in response to recessionary shocks.

Unorthodox monetary policy may work, but it obviously would have to be through channels other than reducing short-term interest rates since they are already at zero. Those channels might include reducing expected short-term rates by tilting down long-term rates, or reducing term or risk premiums in long-term rates. The latter also would tend to reduce long-term rates and exchange rates as well.

Pumping up the monetary base by itself would be unlikely to be effective in doing either of these things, that is, reducing short-term rate expectations or term and risk premiums. Such increases in the base would tend to go into excess reserves and there is no obvious reason why that would change expectations about future rates. Tilting open market operations to a limited degree toward bonds or foreign exchange also is not likely to do much. Studies show that modest changes in the supply of bonds, Operation Twist kinds of things, do not have much effect on bond yields. Sterilized intervention, which is what in effect such foreign exchange buying would be, also does not do much. However, massive purchases of bonds or massive intervention might. The Federal Reserve did set the rate on government bonds during World War II. If a central bank were willing to purchase all the supply of government bonds, it could set the bond rate again, and presumably this would feed through to corporate borrowing rates as well. So, there are extreme policies involving massive purchases that should work in lowering term premiums and risk premiums.

Presented as part of the staff briefing at the June 30-July 1 FOMC meeting in 1998.