In my recent post on how the central banks of Australia, Poland and Sweden should have a look at Bennett McCallum’s MC rule I briefly mentioned how Richmond fed president Al Broaddus already back in 2003 warned that the Federal Reserve should have a plan for how to conduct monetary policy at the the “Zero Lower Bound”. It was of course Bob Hetzel’s brilliant book on the Great Recession that inspired me. In his book Bob quotes Broaddus’ comments at the June 24-25 2003 FOMC meeting.
Here is Broaddus (my bold):
With respect to our strategy and tactics going forward—trying to apply some of the lessons from history and even looking beyond them—I recognize that we may be able to address further disinflation by inducing significant additional reductions in long-term interest rates whether we explicitly target them or not. That’s what most people seem to be thinking about as the next step. But I’d like to add a new dimension to this discussion because bond rates, like short rates, are also subject to a zero bound at some point, which ultimately would put a limit on this policy channel if disinflation persisted or deflation began to threaten us. So I’d like to talk about what I’ll refer to as the “what next” issue for a couple of minutes. That issue is, How should we think about further monetary stimulus if we get to the point where both long- and short-term interest rate policies essentially have been immobilized?
Now, I agree with a lot of other people—although I’m not sure how many people around the table here—that the odds we will face this situation are small and may be exceedingly small. Because of that, it’s tempting to conclude that we have plenty of time and really don’t need to think about this or discuss it yet. In other words, we’ll cross that bridge when we get to it. But I would argue that it’s not only useful but actually urgent that we think about these kinds of options now. I’m building on the point you were making, Cathy, because confronting deflation just like confronting inflation involves a credibility problem. That’s the essence of it for me. Moreover, unlike inflation, the credibility problem in dealing with deflation is compounded by the zero bound on nominal interest rates. That raises at least the possibility that interest rate policy alone can’t deter deflation even if we’re willing to drive both short- and long-term interest rates to zero.
In the current situation—I’m not going to talk about current policy but use that as a framework in this situation—if the funds rate were to get closer to zero, the possibility of deflation has the potential to create deflation expectations and actual deflation simply because people may doubt that we can and will use monetary policy to combat deflation effectively at the zero bound. My concern is that waiting to say or think about how we would deliver further monetary stimulus if rates were to fall to zero could in some circumstances lead the public to conclude that we can’t do it.If people think we can’t deliver, that would risk creating a credibility deficit that could make it much more difficult to deal with this situation if in fact it arises and we try to use different types of policies to deal with it. So that’s why I think it’s essential that we begin to talk about this and consider it now. I’m not talking about developing a detailed strategy but at least putting something on the table.
Let me quickly recapitulate the key points I’ve tried to make here. The first is that, until we work through this “what next” scenario and communicate a credible strategy, addressing it to the public at some point, I think our contingency plans for confronting deflation will be incomplete. In my view, that would be a serious omission. We do a lot of contingency planning at the Fed, and I believe we should do some comprehensive contingency planning on this kind of scenario even if its probability is low. And I would say the sooner the better. We don’t have a stash of credibility as deflation fighters yet. If we delay thinking about and developing a strategy for dealing with further disinflation and it continues—and especially if it accelerates—we could wind up with a sizable credibility deficit.That could make it very difficult for us to employ successfully any strategy that we might be forced to come up with in this kind of situation. So I would just put that view on the table, too.
Today we can only imagine how the world would have looked if the FOMC had listened to Broaddus’ suggestions and put in place “contingency planning” to avoid crisis if the fed funds rate hit the zero lower bound. The FOMC unfortunately failed to do so – and so did the ECB, the Bank of England, the Bank of Japan and basically every single central bank in the world – maybe with the exception of the Monetary Authority in Singapore.
However, it is not to late for other central banks in the world to put in place contingency plans to “automatically prevent” disaster at the zero lower bound. Are you listening in Stockholm, Warsaw and Sydney? In Prague? (I have given up on Frankfurt…)