Lower-for-longer

How does lower for longer work?

In an ELB episode the claim is that lower-for-longer works through a commitment to higher inflation in the future (after the shock that induced the ELB episode dissipates) than would be the case if the central bank arrived at the future date without such a commitment. That higher anticipated future inflation feeds back to the present. The higher inflation today lowers the real interest rate today, which causes intertemporal substitution, that is consumers move expenditure from the future to the present, and this increases demand-determined output in this Keynesian world. […]One issue is that lower-for-longer policies need a number of features in place to work. The central bank needs to be capable of committing, it has to have the intention of following through on the commitment, and it has to know how to meet the commitment.

Does Lower-for-Longer Work?
By: Stephen Williamson – University of Western Ontario

A model to analyze the macro-financial vulnerabilities that arise from lower-for-longer

Tobias Adrian in this paper develops a modelling framework that is well-suited to quantify financial stability risks arising from a lower-for-longer policy. His New Keynesian Vulnerability (NKV) model analyzes the evolution of endogenous risk, assuming that efficient macroprudential tools may not be immediately available to counteract the buildup of financial vulnerability. The NKV model is a standard standard New Keynesian  but with two additional features: a) it introduces financial vulnerability as an additional state variable, and hence the model has four equations; b) adds two new parameters, the first parameter determines the slope of the conditional output volatility (which is proxied by financial conditions) as a function of the expected output gap. The second parameter governs the degree to which expected growth depends on the pricing of risk, and thus it appears in aggregate demand.

The framework laid out in this paper incorporates risk-taking but is otherwise standard. When monetary policy is easy, aggregate demand is stimulated not only via the traditional intertemporal consumption decision channel, but also via the “risk-taking channel.” This extra link generates rich macro-financial feedback effects. High growth is associated with easy financial conditions and relatively small risks to output, but easy financial conditions can increase medium-term risks. Hence a “low for long” monetary policy faces a tradeoff between short-term output growth and medium-term financial stability risks. And the key novel feature of the proposed framework is that it places this balance between short-term gain and medium-term risk at the heart of practical monetary policy making.

“Low for Long” and Risk-Taking
Author: Tobias Adrian
From: IMF