Fed Vice Chairman Stanley Fischer spoke about three related issues associated with the zero lower bound (ZLB) on nominal interest rates and the nexus between monetary policy and financial stability: first, whether we are moving toward a permanently lower long-run equilibrium real interest rate; second, what steps can be taken to mitigate the constraints imposed by the ZLB on the short-term interest rate; and, third, whether and how central banks should incorporate financial stability considerations in the conduct of monetary policy. The experience of the past several years in the United States and many other countries has taught us that conducting monetary policy effectively at the ZLB is challenging, to say the least. And while unconventional policy tools such as forward guidance and asset purchases have been extremely helpful, there are many uncertainties associated with the use of such tools.
Are We Moving Toward a World With a Permanently Lower Long-Run Equilibrium Real Interest Rate?
We start with a key question of the day: Are we moving toward a world with a permanently lower long-run equilibrium real interest rate? The equilibrium real interest rate–more conveniently known as r*–is the level of the short-term real rate that is consistent with full utilization of resources. It is often measured as the hypothetical real rate that would prevail in the long-run once all of the shocks affecting the economy die down. In terms of the Federal Reserve’s approach to monetary policy, it is the real interest rate at which the economy would settle at full employment and with inflation at 2 percent–provided the economy is not at the ZLB.Recent interest in estimates of r* has been strengthened by the secular stagnation hypothesis, forcefully put forward by Larry Summers in a number of papers, in which the value of r* plays a central role. Research that was motivated in part by attempts that began some time ago to specify the constant term in standard versions of the Taylor rule has shown a declining trend in estimates of r*. That finding has become more firmly established since the start of the Great Recession and the global financial crisis.
A variety of models and statistical approaches suggest that the current level of short-run r* may be close to zero. Moreover, the level of short-run r* seems likely to rise only gradually to a longer-run level that is still quite low by historical standards. For example, the median long-run real federal funds rate reported in the Federal Reserve’s Summary of Economic Projections prepared in connection with the December 2015 meeting of the Federal Open Market Committee has been revised down about 1/2 percentage point over the past three years to a level of 1-1/2 percent. As shown in the figure below, a decline in the value of r* seems consistent with the decline in the level of longer-term real rates observed in the United States and other countries.
What determines r*? Fundamentally, the balance of saving and investment demands does so. A very clear systematic exposition of the theory of r* is presented in a 2015 paper from the Council of Economic Advisers. Several trends have been cited as possible factors contributing to a decline in the long-run equilibrium real rate. One a priori likely factor is persistent weakness in aggregate demand. Among the many reasons for that, as Larry Summers has noted, is that the amount of physical capital that the revolutionary IT firms with high stock market valuations have needed is remarkably small. The slowdown of productivity growth, which has been a prominent and deeply concerning feature of the past four years, is another factor reducing r*. Others have pointed to demographic trends resulting in there being a larger share of the population in age cohorts with high saving rates.7 Some have also pointed to high saving rates in many emerging market countries, coupled with a lack of suitable domestic investment opportunities in those countries, as putting downward pressure on rates in advanced economies–the global savings glut hypothesis advanced by Ben Bernanke and others at the Fed about a decade ago.
Whatever the cause, other things being equal, a lower level of the long-run equilibrium real rate suggests that the frequency and duration of future episodes in which monetary policy is constrained by the ZLB will be higher than in the past. Prior to the crisis, some research suggested that such episodes were likely to be relatively infrequent and generally short lived. The past several years certainly require us to reconsider that basic assumption.
Moreover, the experience of the past several years in the United States and many other countries has taught us that conducting monetary policy effectively at the ZLB is challenging, to say the least. And while unconventional policy tools such as forward guidance and asset purchases have been extremely helpful, there are many uncertainties associated with the use of such tools.
I would note in passing that one possible concern about our unconventional policies has eased recently, as the Federal Reserve’s normalization tools proved effective in raising the federal funds rate following our December meeting. Of course, issues may yet arise during normalization that could call for adjustments to our tools, and we stand ready to do that.
The answer to the question “Will r* remain at today’s low levels permanently?” is that we do not know. Many of the factors that determine r*, particularly productivity growth, are extremely difficult to forecast. At present, it looks likely that r* will remain low for the policy-relevant future, but there have in the past been both long swings and short-term changes in what can be thought of as equilibrium real rates Eventually, history will give the answer.
But it is critical to emphasize that history’s answer will depend also on future policies, monetary and other, notably including fiscal policy.
