Transcripts of the monetary policymaking body of the Federal Reserve from 2002–2008.

Thank you, Mr. Chairman. I guess before I start, I just want to say that I generally agree with everything everyone is saying. This is a dire situation, and I am perfectly comfortable with that assessment. What I want to do with my comment here is just put on the table one idea about why a rate reduction might be counterproductive. That is what I’m trying to do here.

The U.S. economy now appears to be in recession. Intensified financial market turmoil and very fluid expectations have created a very difficult situation. A key question for the Committee is what to do with the monetary policy piece of the policy response to the situation. We know that monetary policy is a blunt instrument that does not directly address fundamental problems in financial markets. We have other programs in place to try to address those problems more directly. We also have important fiscal actions, which are probably having the largest effect in trying to stabilize the current situation. Unlike the ECB, we already lowered nominal interest rates aggressively earlier this year in anticipation of the possibility of weak macroeconomic performance. We are now in the middle of a further round of easing, which is threatening to send nominal interest rates to zero, given the force of events.

Is this the optimal policy, or could it backfire on the Committee? I want to at least lay out the possibility that a very low nominal interest rate policy may be counterproductive. My key worry is that housing markets remain at the core of the current turmoil. Mortgage markets— $14 trillion or so, about one GDP—are based on nominal contracts. Deflation tends to be very destructive in an environment of nominal contracting. I want to stress that macroeconomic expectations are very important for the way the economy actually evolves and will evolve going forward and that those expectations are very fluid in the current environment. The Japanese experience, while it is not an exact parallel, represents an important reference point for the current situation. Japan’s problems were very real. Some have described the outcome as a lost decade.

So let’s turn to the graph here for just a second. This is what I was talking about yesterday. This is an argument put forward by Jess Benhabib, Stephanie Schmitt-Grohé, and Martín Uribe. On the vertical axis is the nominal interest rate. On the horizontal axis are the inflation rate and inflation expectations, which in this graph are going to be the same thing. The diagonal line labeled “Fisher” is just a Fisher relationship. The nominal interest rate is the real interest rate, r, plus inflation expectations. Then policy is described by the line with the kink in it. The policy line means that, when medium-term inflation expectations are above target, we raise the nominal interest rate and, when medium-term inflation expectations are below target, we lower the nominal interest rate. That works beautifully around the targeted equilibrium, the π* in this environment, and all goes well. It’s just that, when you go to low nominal interest rates, strange things start to happen because you have to do something with policy as you come to very low nominal interest rates. You could just go to zero, and then you would have the horizontal line labeled “policy” that would go across all the way to the minus r there. Or you could stop at some earlier level. I chose something here to illustrate what the Greenbook seems to have in mind, say ½ percent.

But any way you cut it, this is going to create another crossing of the Fisher relation and create a second steady state. This is the main point of the Benhabib analysis. You can layer on top all kinds of other stuff that you would like to include in your model, but most models are going to have a Fisher relationship, and most models are going to have the policymaker reacting by adjusting the nominal interest rate. So this other steady state, the steady state with low nominal interest rates, has deflation. If you get stuck there, in our current environment, this would exacerbate the housing problem a lot and make our problems much more severe. So this is just one caution about going to a very low nominal interest rate environment. When I saw this six or seven years ago, it had some influence on me. Before this, I was not worried about any of the zero bound issues. But then, this does make me a little nervous, given the core problem in our situation, which is the housing problem. That’s the argument. So let me set that aside then.

One thing this line of research pointed out—and a whole bunch of papers have been written since this paper—is the existence of this second steady state and that the deflation associated with the trap steady state is a worrisome phenomenon. There are two steady states here. You can just argue that you don’t think the lower one is going to be the one the economy coordinates on and that eventually we are going to go back to the high one and that is perfectly fine. However, the Japanese case seemed to be zero nominal interest rates and a moderately low rate of deflation for quite some time. You could say that, if we coordinate on this low nominal interest rate steady state, we can somehow take fiscal policy actions to move off that to the other steady state. That is a more complicated issue. That has been addressed in the literature, and that is also a reasonable thing to say. I guess my main concern about this is, since it is a very dire situation and I think we are going to go very close to zero very soon, I want us to do it with our eyes open. It has some possibility of creating a worse environment. That is the only thing I wanted to say here.

So my preference based on this would be to leave rates alone and say, “Let’s use fiscal policy.” I don’t think what we have now is an interest rate problem. What we have now are problems in credit markets, and I think they are being fairly well addressed by the most recent fiscal actions, including capital injections into the banking sector. So that would be my preference at this point.

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