Stanley Fischer: Monetary policy, financial stability, and the zero lower bound
Central bank: fed | Type: speech | Date: 2016-01-03

## Stanley Fischer: Monetary policy, financial stability, and the zero lower boundSpeech by Mr Stanley Fischer, Vice Chair of the Board of Governors of the Federal Reserve System,

at

the

Annual

Meeting

of

the

American

Economic

Association,

San

Francisco, California, 3 January 2016.*

*

*I am grateful to James Clouse, William English, Thomas Laubach, Nellie Liang, David Lopez-Salido, Jeff Marquardt, David Mills, Fabio Natalucci, David Reifschneider, Stacey Tevlin, David Wilcox, and Paul Wood for their assistance.

I have benefited also from discussions with John Williams.

My comments today reflect my own views and are not an official position of the Board of Governors or the Federal Open Market Committee.Thank you.

It is a great pleasure to be here today and to participate in this panel together with such a distinguished group.Much has happened in the world of central banking in the past 10 years.

The list of challenges we face is long and includes fundamental issues such as lender-of-last-resort policies in the modern financial system, the role of central banks in the supervision of the financial sector, and the appropriate role of forward guidance in monetary policy communications.

Those are the topics I will not discuss today.Rather, I will focus primarily on 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 shortterm

interest

rate;

and,

third,

whether

and

how

central

banks

should

incorporate

financial stability considerations in the conduct of monetary policy.

## 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. 1

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. 2

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. 31 See Laubach and Williams (2003).2 See Summers (2014, 2015).3 This research includes recent work by Kiley (2015) and others that uses extensions of the original Laubach and Williams (2003) framework.

An international perspective on medium-to-long-run real interest rates is provided by U.S. Executive Office of the President (2015).

Reinhart and Rogoff (2009) and Hall (2014) discuss the longlived effects of financial crises on economic performance.

See also Hamilton and others (2015).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 longrun 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. 4

As shown in the figure , 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*. 5 Others

have

pointed

to

demographic

trends

resulting

in

there

being

a

larger

share

of

the population in age cohorts with high saving rates. 6

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. 7Whatever 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. 8 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. 9 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. 10I 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 federal4 The projections materials associated with the Federal Open Market Committee's December 2015 meeting are available on the Board's website at It is also a major factor explaining the phenomenon of the economy's impressive performance on the jobs front during a period of historically slow growth.6 See, for instance, Gordon (2014, forthcoming).7 See Bernanke (2005).

See also the recent work by Caballero, Farhi, and Gourinchas (2008) and Mendoza, Quadrini, and Rios-Rull (2009).8 See, for instance, Reifschneider and Williams (2000), Blanchard and Simon (2001), and Stock and Watson (2003).9 For a discussion of various issues reviewed by the Federal Open Market Committee in late 2008 and 2009 regarding the complications of unconventional monetary policy at the ZLB, see the set of staff memos on the Board's website at 

See Williams (2013).BIS central bankers' speechesfunds

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.

## What steps can be taken to mitigate the constraints associated with the ZLB?Against that backdrop, a second key question for central banks is, What steps, if any, can be taken to mitigate the constraints associated with the ZLB?- Raising the Inflation Target :

One step that has been proposed by many, including Olivier Blanchard, is the possibility of raising the target rate of inflation from 2 percent to some higher level.

One concern I have raised in the past about such proposals is that high levels of inflation may also be associated with higher inflation variability.

The welfare costs of high and variable inflation could be substantial.

For example, more variable

inflation

would

make

long-run

planning

more

difficult

for

households

and businesses.

And higher and more variable inflation would likely also lead to higher levels of indexation in the economy over time that, in turn, would make it more difficult for central banks to achieve their inflation goals.- Negative Interest Rates : Another possible step would be to reduce short-term interest rates below zero if needed to provide additional accommodation.

Our colleagues in Europe are busy rewriting economics textbooks on this topic as we speak - and also helping us to remember earlier discussions of negative interest rates by Keynes, Irving Fisher, Hicks, and Gesell. 11To

provide

further

monetary

accommodation

amid

weak

inflation

prospects,

the

European Central Bank lowered its deposit rate into negative territory in June 2014 and twice cut it further, most

recently

to

minus

0.30

percent

in

December.

The

Riksbank

has

lowered

its

key repurchase agreement, or repo, rate to a similar level, while the central banks of Denmark and Switzerland have cut their key policy rates more deeply, to minus 0.75 percent, in large part to offset considerable appreciation pressures on their currencies.In each of these countries, short-term money market rates declined along with policy rates.

Moreover, while it is hard to distinguish the effects of the rate cuts from those of concurrent asset purchase expansions, the easing appears to have been transmitted to assets of longer maturity and greater risk.

Bond yields and bank lending rates declined, and, in the euro area, the volume of lending to corporations and households picked up notably.

In addition, the rate cuts into negative territory have acted as expected through the exchange rate channel.Negative policy rates have generally not been associated with the problems that likely were anticipated.

Adverse effects on money market functioning have been limited.

Cash holdings have

not

risen

significantly

in

these

countries,

in

part

because

of

nonnegligible

costs

of insuring,

storing,

and transporting

physical

cash.

These favorable outcomes may be partly because significant shares of deposits at central banks in these countries are not subject to11

The Europeans have long been intrigued by the possibility of negative rates, beginning with Gesell's stamp scrip proposal in 1906 and some apparently successful experiments with stamp scrip in Austria in the 1930s.

See Keynes (1936), Fisher (1933), and Hicks (1937).

For an extensive discussion of Gesell's work, see Keynes (1936), chap. 23, pp. 353-58.negative rates.

It is unclear how low policy rates can go before cash holdings rise or other problems

intensify,

but

the

European

experience

has

certainly

shown

that

zero

is

not

the effective lower bound in those countries.Could negative interest rates be a policy response that the Federal Reserve could choose to employ in a future crisis?

One possible concern with a strategy of this sort in the United States is the potential for destabilizing effects in money markets.

For example, various observers have noted that negative rates could lead to scenarios in which money funds 'break the buck' or simply shut down, either of which could generate strains in money markets.

Another concern is whether the complex and interconnected infrastructure supporting securities transactions in the U.S. financial system could readily adapt to a world of negative interest rates.

For example, similar to the types of issues addressed ahead of the year 2000, there could well be automated systems

that

simply

are

not

coded

properly

at

present

to

process

transactions

based

on instruments with negative rates.

All of these are, of course, transitional problems, but they might be sufficient to make a move to negative rates difficult to implement on short notice.- Raising the Equilibrium Real Rate :

An

even more ambitious approach to ease the constraints posed by the zero lower bound would be to take steps aimed at raising the

equilibrium

real

rate.

For

example,

expansionary

fiscal

policy

would

boost

the equilibrium real rate.

In particular, the need for more modern infrastructure in many parts

of

the

American

economy

is

hard

to

miss.

And

we

should

not

forget

that additional

effective

investment

in

education

also

adds

to

the

nation's

capital.

As another

example,

numerous

studies

of

the

effects

of

the

Federal

Reserve's

asset purchases suggest that these operations have reduced the level of the term premium embedded in long-term interest rates.

If aggregate demand depends primarily on the level of long-term interest rates, it might be possible, in principle, to maintain a level of long-term rates consistent with full employment and stable prices by lowering term premiums

while

at

the

same

time

raising

the

level

of

short-term

rates

by

a compensating

amount.

This

result

could

be

accomplished,

for

example,

if

the Treasury took steps to shorten the average maturity of Treasury debt outstanding or, alternatively, if the Federal Reserve maintained large holdings of long-term assets.- Eliminating

the

ZLB

Associated

with

Physical

Currency :

While

the

European experience suggests that interest rates can be pushed somewhat below zero, the existence

of

physical

currency

likely

still

limits

how

deeply

interest

rates

can

be pushed into negative territory.

That observation has led some to ask whether it would it be possible for the financial system to operate effectively without physical currency provided

by

the

central

bank.

This

is

a

theoretical

question

that

has

fascinated economists

for

decades

and,

with

advances

in

technology,

could

possibly

have practical implications as well.

Indeed, the Scandinavian countries have embraced the development of new payments technologies that seem to be reducing the need for physical currency for transactions in those countries. 12 Nonetheless, a transition to a cashless economy in the United States seems very far off; indeed, U.S. currency outstanding

has

been

increasing

relative

to

nominal

gross

domestic

product

over recent

decades,

driven

importantly

by

foreign

demands

for

U.S.

bank

notes.

Moreover, to eliminate the ZLB associated with physical currency by going cashless, countries would need to transition to an economy that did not require widespread use of physical currency, and central banks in those countries would need to cease issuing physical

currency

on

demand

(for

example,

in

response

to

demands

spurred

by negative rates on so-called inside money). 13 For all of these reasons, as a practical12

See Alderman (2015).13

As an alternative to eliminating currency, a number of authors - including Goodfriend (2000), Buiter (2003), Agarwal and Kimball (2015), McAndrews (2015), and Rogoff (2014) - have discussed various mechanisms that could effectively implement a Gesell tax on physical currency.BIS central bankers' speechesmatter

at

least

for

the

United

States,

it

seems

highly

unlikely

that

the

constraints associated with the ZLB could be meaningfully addressed by steps to encourage a transition to a cashless economy.None of these options for dealing with the difficulties of the ZLB suggest that it will be easy either to raise the equilibrium real rate or to mitigate the constraints associated with the ZLB.

But when the real rate is close to zero, even small effects can make a noticeable difference.

And, of course, such issues are clearly worthy of additional research.

## How should central banks incorporate financial stability considerations in the conduct of monetary policy?The challenges associated with the ZLB and the potential risks resulting from an environment of extremely low rates for a prolonged period of time bring me to the third question: How should central banks incorporate financial stability considerations in the conduct of monetary policy?

Or, put another way, can we conduct monetary policy in a way that reduces the likelihood of financial instability? 14The first response of policymakers to the question of whether monetary policy - defined as the short-term

policy

interest

rate

-

should

be

used

to

support

financial

stability

is

to

say

that macroprudential tools, rather than adjustments in short-term interest rates, should be the first line of defense.Macroprudential

tools

are

primarily

regulatory

or

supervisory

in

nature

and

target

specific activities,

markets,

and

financial

institutions.

In

the

United

States,

we

now

have

some experience with such tools.

The interagency guidance on leveraged lending issued in 2013 and the annual coordinated stress tests (the Dodd-Frank Act stress test, or DFAST, mandated by

the

Dodd-Frank

Wall

Street

Reform

and

Consumer

Protection

Act

of

2010;

and

the Comprehensive Capital Analysis and Review, or CCAR), focused on the capital adequacy of the largest banking firms, are two examples implemented for a few years now and for which data are available for an assessment of their effectiveness. 15An important new element of the post-crisis capital regime is the Countercyclical Capital Buffer (CCyB), which the Federal Reserve put out for comment on December 21, 2015. 16 The CCyB is designed to be activated when there is an elevated risk of above-normal losses in the future and released when the risk of above-normal losses recedes.

The higher levels of capital would increase the resilience of the largest banks because they would be better positioned to absorb the losses.Despite the tools that the Fed can use to support financial stability, including the Fed's authority to

impose

margin

requirements

on

secured

financing

transactions,

the

Fed

has

fewer macroprudential tools at its command than some other central banks, particularly with respect to real estate.

Regulators in many countries facing or anticipating problems with rising real estate prices often turn to controls over loan-to-value or debt-to-income ratios.

Such measures are

potentially

important,

as

the

real

estate

sector

is

the

most

common

source

of

the beginnings of financial instability.

In the United States, responding to such problems with these tools

would

require

interagency

coordination,

which

could

make

their

use

cumbersome

at critical moments.It is important to acknowledge that there remain cases in which macroprudential tools are either not available or have not been sufficiently tested in the United States, or they may be in conflict14

See International Monetary Fund (2015) for a broad discussion of many issues in this area.15

More information about DFAST and CCAR is available on the Board's website at 

See Board of Governors (2015).with other objectives such as widespread access to credit.

The effective lack of such tools has two important consequences.

First, it requires placing greater weight on the ability of financial institutions

and

the

financial

system

as

a

whole

to

withstand

financial

shocks

without

the authorities having to use macroprudential instruments - that is to say, on structural reforms to the financial system.

Second, in such instances, one could consider using monetary policy the short term policy interest rate - to lean against the wind of financial stability risks. 17The use of monetary policy to address financial stability concerns raises two distinct but closely related

sets

of

questions.

The

first

is

whether

adjustments

in

the

policy

rate

can

indeed enhance financial stability by reducing either the odds of a financial crisis or the severity of such a crisis once it is under way - and, if so, through which channels. 18Provided that the first question is answered in the affirmative, the second question is how leaning against the wind interacts with the traditional objectives of monetary policy - namely, the employment and inflation mandates in the United States.

This tradeoff could be small or even nonexistent when both traditional macro objectives and financial stability objectives call for the same policy action - for example, when the credit cycle is approaching its peak, output is above potential, and inflation pressures appear to be building.

In contrast, when different objectives call for different policy actions - for example, when some financial assets appear overvalued but economic growth remains tepid and inflation is subdued - policymakers may find

this

tradeoff

much

more

difficult

to

assess

and

will

search

for

macroprudential

tools.

Perhaps unsurprisingly, recent contributions in the literature that quantify this tradeoff point to a

range

of

recommendations,

with

some

reporting

an

optimal

monetary

policy

that

leans against the wind and some suggesting otherwise. 19I would like to conclude on this issue by saying that the issue is a bit more complicated than suggested so far - for, given that financial

variables

are

a

critical

part

of

the

transmission mechanism of monetary policy, when policymakers say the economy is overheating, they may well be considering the behavior of asset prices as a critical part of that phenomenon and part of

the

reason

to

tighten

monetary

policy.

Thus,

I

believe

that

the

real

issue

of

whether adjustments

in

interest

rates

should

be

used

to

deal

with

problems

of

potential

financial instability is macroeconomic, and that if asset prices across the economy - that is, taking all financial markets into account - are thought to be excessively high, raising the interest rate may be the appropriate step.

Further discussion of this issue will probably bear considerable similarity to the analysis of how to deal with asset bubbles that took place in the United States in the decade starting about two decades ago.

## ConclusionIn closing, let me concede that it is easier to pose these questions than it is to answer them definitively.

The issues are both deep and interesting.

Along with other monetary policy issues, particularly the role of the lender of last resort in a world of significant uncertainty, they deserve the attention the profession in both academic and governmental institutions is, will be, and should be giving them.17

See, for instance, Stein (2013) and Carlson and others (forthcoming) for a discussion on the possible use of monetary policy tools to foster financial stability objectives.18

Implicit in this discussion is some degree of confidence that the central bank could identify a buildup of financial stability risks.

Adrian, Covitz, and Liang (2014) offer some views on effective financial stability monitoring.19

This variability is in part due to different model set-ups, such as how financial instability builds up and how it affects economic outcomes.

For example, Woodford (2012) finds that leaning against the wind does not change the basis for traditional stabilization objectives in a standard New Keynesian model, whereas the cost-benefit analysis in Svensson (2015) finds little basis for the 'leaning against the wind' strategy.

Ajello and others (2015) find that optimal adjustment of the policy rate, when the possibility of a crisis is taken into account, is small unless the policymaker is assumed to be quite uncertain about the likelihood and severity of the crisis.

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## 10-Year Real Treasury YieldsNote: The data are quarterly.

The yield using survey-based inflation expectations is the difference between the 10-year nominal Treasury yield and a surveybased measure of 10-year inflation expectations taken from the FRB/US model.

TIPS is Treasury Inflation-Protected Securities.

Source: Federal Reserve Bank of New York; Barclays; Federal Reserve Board staff calculations.