Long spells of low interest rates: implications for monetary policy

This paper takes a critical look at the conceptual and empirical underpinnings of prevailing explanations of low real (inflation-adjusted) interest rates over long horizons and finds them incomplete. The role of monetary policy, and its interaction with the financial cycle in particular, deserves greater attention. By linking booms and busts, the financial cycle generates important path dependencies that give rise to intertemporal policy tradeoffs. Policy today constrains policy tomorrow. The policy regime is not neutral and can exert a persistent influence on the economy’s evolution, including on the real interest rate. This raises serious conceptual and practical questions about the use of the natural interest rate as a monetary policy guidepost.

The challenges to effective countercyclical monetary policy presented by the possibility, in fact the probability, of returning to the ELB in future recessions have highlighted the potential importance of nonmonetary policy tools, such as federal fiscal policy, state and local fiscal policy, and even bank regulatory policy, as necessary sources of countercyclical stabilization policy. However, to implement such policies effectively, policymakers must be both willing and able to use them, which requires both the desire to use the available countercyclical tools and policy buffers of a size sufficient for them to be useful.