A reading of this essay is featured on the Metaculus Journal Podcast here.
There is a broad consensus that monetary policies set by central banks like the Federal Reserve or European Central Bank are critical to avoiding depressions like the global Great Recession, and for ensuring that real economic shocks like COVID-19 do not have unnecessarily harmful economic consequences.
These central bank monetary policies have evolved significantly in the 15 years since the Great Recession of 2007-2009.
This is in contrast to the prior period, from the early 1980s up to 2007, when monetary policy enjoyed a (comparatively) successful and smooth run – particularly as conducted by the US Federal Reserve. This “Great Moderation” period saw only two shallow recessions in the US, in 1990-1 and in 2001. Many credit the macroeconomic stability of this period to the steady policy of the Fed, which was aimed at predictably achieving a low and stable rate of inflation: a policy of “inflation targeting”. Although the situation in Europe was more complicated – with the reunification of Germany; issues with pegged exchange rates; and the eventual adoption of the Euro – EU unemployment and inflation were also fairly stable.
The challenge of the ZLB
This changed with the onset of the Great Recession in 2007, and in particular, when developed country central banks hit the zero lower bound.
As background, since the early 1980s, central banks have communicated their operation of monetary policy by setting a policy nominal interest rate. For example, the Fed in the US communicates the stance of monetary policy through its target for the federal funds rate (FFR); the Bank of England communicates the stance of monetary policy through its direct control of the official bank rate. (This in contrast to e.g. Milton Friedman's famous proposal for a rule for the growth rate of the monetary base.)
Since all interest rates in an economy are linked by arbitrage pressure, the Fed by controlling the FFR can affect more general interest rates facing consumers and businesses – such as interest rates on bank deposits. The consensus understanding of monetary policy is that by controlling the current and expected future path of these interest rates, central banks can influence economic activity: GDP, inflation, unemployment, and other metrics.
However, it has long been believed that central banks cannot push their policy rates much below zero. This is because of a no-arbitrage relation with physical cash. By holding physical cash, you can guarantee yourself a 0% nominal return: if you have 100 dollars in cash in your wallet today, you can ensure that you'll have 100 nominal dollars in your wallet next year, therefore guaranteeing a 0% nominal return. Thus, if the central bank tried to set its policy rate to cause the nominal bank deposit rate to be (say) -20%, then most everyone would pull their money out of the banking system and hold cash instead, to obtain the higher interest rate. (This is essentially a form of Gresham's Law: Central banks peg physical cash and bank reserves at a 1:1 rate; but the rate of return on the two need not be the same.)
This zero lower bound (ZLB) on nominal interest rates however is not a hard limit: because of the costs and inconvenience of storing cash and preventing theft, individuals and firms are willing to accept a somewhat negative nominal interest rate. Indeed, in Europe, the policy rate has been slightly negative since 2014, and this has spilled over to interest rates facing households, such as mortgage rates in Denmark.
In the United States, unlike with the ECB in the Eurozone, the Fed has been unwilling to target a policy rate even modestly below zero. Various Fed officials have argued (among other things) that they lack the legal authority to do so; or that benefits would not be large enough to outweigh some perceived risks.
Because the nominal policy rate cannot go (too) negative due to the existence of cash, it is commonly believed – though disputed – that this serves as a significant constraint on the power of monetary policy. For example, in December 2008, the Fed's policy rate of the FFR effectively hit the ZLB and was thought to be unable to go much lower; however, it is likely that were there no zero lower bound, the Fed would have wanted to cut rates further to prevent the ongoing Great Recession. The ZLB prevented this. Similarly, the eurozone has been stuck at or slightly below the ZLB since 2014, but it is likely that the ECB would have cut rates further, if it believed it were able to do so.
Repeated ZLB episodes
If the experience of the ZLB during the Great Recession was merely a one-time event, it would be less of a cause for concern: an exceptional macroeconomic curiosity. However, although it seems to have been underappreciated in the 2010s due to wishful thinking, it appears quite likely that developed countries will frequently find themselves with interest rates stuck at the ZLB in coming decades.
Indeed, the Eurozone never truly left the ZLB after the Great Recession. The United States left in 2015 but returned to the ZLB during the COVID-19 recession, until March 2022.
Nonetheless, it seems highly probable that the US will hit the ZLB in whatever the next economic crisis may be. Policy rates will be stuck at zero, even though it would be economically optimal have negative rates.
Abolishing the ZLB, abolishing cash
Understanding the frequency of ZLB episodes is important for policymakers considering how to best prevent recessions and achieve macroeconomic stability. The more frequent these episodes, the more important it is to consider policy reforms that would allow for us to better handle or even to wholly overcome the ZLB.
One policy that has been proposed to overcome the ZLB is abolition of cash. Removing cash would remove easy access to a financial instrument which provides a guaranteed, safe 0% nominal return – and would therefore break the no-arbitrage argument which enforces the zero lower bound on nominal interest rates. There are other arguments for abolishing cash: most prominently, to reduce tax evasion. On the flip side, some argue that abolishing cash would force individuals to conduct all of their transactions via the banking system, reducing privacy. (Plausibly, the development of privacy-preserving cryptocurrency technology reduces this concern.) Under this argument, then, the efficiency case for abolishing cash depends on the tradeoff of costs versus benefits.
Policy regime changes
Another strategy for central banks operating in the new world of frequent ZLB episodes would be to alter their entire policy frameworks in ways to reduce the ZLB problem. Proponents of various framework changes (discussed below) also argue that such changes would have other stabilizing benefits, even setting aside the issue of the zero lower bound.
For background, policies of “inflation targeting” have dominated in developed country central banks for the last three or four decades, implicitly or explicitly. Under this policy, central banks explicitly aim for some target rate of inflation (or target range) each year.
- The ECB, as of 2021, has a symmetric, medium-term 2% inflation target.
- The Fed has since the 1990s been thought to operate under an implicit inflation target of 2%, which it formalized in a 2012 statement.
More recently, the Fed has adopted a policy which has become known as “flexible average inflation targeting”, where it has stated or implied a willingness to allow inflation to go somewhat above 2% if inflation had been below 2% in the recent past; and vice versa for recent inflation overshoots. Economic theory predicts that this sort of “make-up policy”, compared to the prior policy of implicitly “letting bygones be bygones”, is very beneficial for avoiding recessions – particularly at the ZLB – by anchoring expectations for the future price level.
An even more radical change than the adoption of “average inflation targeting” would be an explicit policy of “level targeting”. Under (for instance) ‘price level targeting’, the central bank would commit to a future path for the price level, promising to continually target a price level growing at (say) 2% each year. Under such a policy, the Fed would be committing itself to make up for – at a 1-for-1 rate – any misses or overshoots in inflation in past. (The price level is the integral of the inflation rate.) For example, if inflation had been 1% last year after many years of 2%, this would commit the Fed to aim for 3% the next year (to a first-order approximation), to bring the price level back to the promised path. Average inflation targeting, as mentioned above, is a vague version of this.
Alternative policy targets
Perhaps the most popular alternative policy regime would target stable nominal GDP (NGDP) growth, rather than stable inflation. Nominal GDP growth is equal to (by definition) the sum of inflation and real GDP growth:
For example, the Fed might target 4% NGDP growth each year, expecting on average 2% growth in real GDP and therefore 2% inflation on average.
Under NGDP targeting, the central bank would allow inflation to rise when real growth is low (and vice versa). Many economists argue that such a policy would better prevent economic fluctuations (particularly at the ZLB) but also more generally (see also: , , , ).
Another alternative policy regime would target stable growth in nominal wages. Under nominal wage targeting, the central bank would aim for stable growth in an index of nominal wages in the economy. For example, the Fed might target 3.5% annual growth in an appropriate index of nominal wages, reflecting expectations for on average 1.5% growth in labor productivity and 2% inflation. (For more on nominal wage targeting, see , , .)