Monday, November 25, 2013

NGDP targeting and escaping the ZLB

Much of the innovations in monetary policy in the aftermath of the Great Recession have been driven by the compulsions of monetary accommodation when the interest rates are at the zero-lower bound (ZLB). It started with direct credit injection through unlimited liquidity auction windows, lowering collateral requirements and so on. Then, the quantitative easing policies sought to leverage the central bank's balance sheet by purchasing securities, private and government, undertaking maturity transformations in government securities etc, thereby "rebalance portfolios" to lower real interest rates. Finally, central banks are now, through forward guidance, seeking to shape market expectations through credibly committing to remain accommodative over a long-time horizon so as to restore normalcy in the economy.

The net result of all these policies is that we have had five years of ultra-cheap money and sustained recovery does not appear to be any closer. More worryingly, these policies have induced several distortions in the financial markets. Furthermore, any exit from the accommodation, before recovery has taken firm hold, threatens to destroy both the gains so far as well as trigger off a contagion across the emerging markets.

Amidst all this, the ZLB continues to bind, and looks set to do so for the foreseeable future. This, by itself is severely limiting on the effectiveness of monetary policy, and demands an exploration for new monetary policy frameworks. In this context, a new paper by economists at the US Federal Reserve Board argue that a revised monetary policy framework, like NGDP targeting, may be effective at overcoming the ZLB constraint. It has raised commentaries here and here in Free Exchange.

The paper explores various scenarios of monetary policy over the medium-term and finds that interest rates are not likely to rise beyond 4%, even by 2019. The likelihood of the US economy tipping to the next cycle of recession by then is very strong, thereby leaving the Fed with limited space to cut rates and adopt an accommodative stance with its monetary policy. In other words, the problem of ZLB is here to stay with us, ironically as a result of the global success with taming the high inflation trend. This raises the issue of how to design a monetary policy framework that can be responsive even when faced with the ZLB.

This has the potential to be very relevant for monetary policy debates in the coming years. Nominal interest rates remain low and will continue to be so for the foreseeable future. Further, deflationary pressures remain strong on both sides of the Atlantic. Even with economic recovery taking hold and interest rates rising, there is the strong likelihood that many developed economies will move into the next recessionary trough with far lower rates than would be enough to sustain the necessary monetary accommodation to recover from the recession. Inflation Targeting is likely to be a blunt instrument. An NGDP target is more likely to generate the thrust required to restore economic growth.  

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