Ferguson, Roger

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.