James Bullard:

Again, the data in this Figure do not mix at all— it’s boxes on the right [US] and circles on the left [Japan]. But the most recent observation for the U.S., the solid box labelled “May 2010,”is about as close as the U.S. has been in recent times to the low nominal interest rate steady state. It is below the rate at which policy turns passive in the diagram. In addition, the FOMC has pledged to keep the policy rate low for an “extended period.”This pledge is meant to push in‡ation back toward target— certainly higher than where it is today— thus moving to the right in the Figure. Still, as the Figure makes clear, pledging to keep the policy rate near zero for such a long time would also be consistent with the low nominal interest rate steady state in which in‡ation does not return to target but instead both actual and expected in‡ation turn negative and remain there. Furthermore, we have an example of an important economy which appears to be in just this situation.

How might one get out of such a deflationary expectations trap? By credibly committing to an expansionary monetary policy. That Japan has had near-zero rates for an extended period of time shows that it has failed to credibly commit to an expansionary monetary policy. One could say that they are in a “trap”…but for a decade? Please.

The policymaker is completely committed to interest rate adjustment as the main tool of monetary policy, even long after it ceases to make sense (long after policy becomes passive), creating a second steady state for the economy. Many of the responses to this situation described below attempt to remedy this situation by recommending a switch to some other policy in cases when in‡ation is far below target. The regime switch required has to be sharp and credible— policymakers have to commit to the new policy and the private sector has to believe the policymaker.

Unfortunately, in actual policy discussions nothing of this sort seems to be happening.

Bullard goes on to give possible explanations for the Fed remaining passive in the face of a dangerous deflationary risk:

  • Denial: Japan’s experience was unique to some feature of Japan itself, and cannot happen in the US. But perhaps we have quirky features as well?
  • Stability: We should be content with any given “steady state” equilibrium, for stability sake. This is what I believe happened in Japan.
  • FOMC, 2003: A false sense of security provided by the reaction to “low interest rates for an extended period” the last time the US faced a deflationary risk.

And lest you wish to rest on your old Keynesian laurels:

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 not simply abandoning interest rate rules altogether.
The advice has a certain structure. It involves not changes to the way monetary policy is implemented, but changes in the fi…scal stance of the government. By itself, this makes the practicality of the solution much more questionable.

[...]

The described solution has the following f‡avor: The government threatens to behave unreasonably if the private sector holds expectations (such as expectations of very low in‡ation) that the government does not desire. This threat, if it is credible, eliminates the undesirable equilibrium. Some authors have criticized this type of solution to problems with multiple equilibria as “unsophisticated implementation.”*

[H/T Kevin Drum]

*Sophisticated Monetary Policies; Atekson, Chari, Kehoe

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