Evaluating monetary policy at the zero lower bound.

Abstract

Evaluating the stance of monetary policy has become very challenging. In the past, policymakers could simply compare the target federal funds rate to the prescriptions from simple policy rules to get a sense of whether the stance of policy was appropriate given economic conditions. However, as the economy fell deep into recession in 2008, the Federal Open Market Committee (FOMC) lowered its target for the federal funds rate to its effective lower bound. Since then, and until recently, many of the simple rules that have guided policy in the past have prescribed a negative federal funds rate target. However, with the federal funds rate constrained by the zero lower bound (ZLB) on nominal interest rates, the FOMC could not move the target federal funds rate below zero.Instead, the FOMC turned to a number of unconventional policies to provide additional monetary accommodation. These other policies included several large-scale asset purchase programs and the use of guidance. Purchases of longer-term Treasury and agency mortgage-backed securities resulted in an expansion of the Federal Reserve's balance sheet to more than $4 trillion. Forward guidance provided market participants information about how long the federal funds rate target might remain at its effective lower bound and how steep its trajectory might be after liftofffrom zero. These policies are widely viewed as having put downward pressure on longer-term interest rates, providing additional monetary accommodation even though short-term rates remained constrained by the ZLB.With the implementation of unconventional policies, there currently is no single, directly observable indicator that can summarize the stance of policy. Moreover, the economics literature provides no generally accepted rule for how unconventional policies should be adjusted in response to changing economic conditions. As a result, policymakers have had to use considerable judgment and discretion to calibrate the stance of policy in the aftermath of the Great Recession.This article addresses these challenges by using a federal funds rate to assess the overall stance of monetary policy. The shadow federal funds rate-based on research by Jing Cynthia Wu and Fan Dora Xia and by Leo Krippner-is a summary measure of the total accommodation provided by conventional and unconventional policies. It provides an estimate of what the federal funds rate would be, given asset purchases and forward guidance, if the federal funds rate could be negative. More precisely, it represents the policy rate that would generate the observed yield curve if the ZLB were not binding.This shadow federal funds rate is then compared to the prescriptions from a policy rule estimated over a period of relative macroeconomic stability. The estimated rule shows how monetary policy responded in the past to economic conditions. The specification of the rule reflects the Federal Reserve's dual mandate of price stability and maximum employment. It prescribes a setting for the federal funds rate that depends on the deviation of inflation from the FOMC's medium to long-term objective of 2 percent and on two indicators of labor market activity that summarize a wide range of variables. The labor market indicators replace the unemployment or output gaps traditionally used in policy rules based on the concern that, currently, the unemployment rate may not be a reliable indicator of economic slack and that the output gap is difficult to measure in real time.Based on deviations of the shadow federal funds rate from the prescriptions of the estimated policy rule, policy was not sufficiently accommodative in the immediate aftermath of the Great Recession but became considerably more accommodative over time. While the unconventional policies adopted by the FOMC were effective in pushing the shadow federal funds rate well below zero, they did not initially lower it sufficiently to reach the level prescribed by the estimated rule. …

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