Janet L Yellen: The Federal Reserve's monetary policy toolkit - past,
present, and future
Speech by Ms Janet L Yellen, Chair of the Board of Governors of the Federal Reserve
System, at the Federal Reserve Bank of Kansas City Economic Symposium "Designing
resilient monetary policy frameworks for the future", Jackson Hole, Wyoming, 26 August
2016.
* * *
The Global Financial Crisis and Great Recession posed daunting new challenges for central
banks around the world and spurred innovations in the design, implementation, and
communication of monetary policy. With the U.S. economy now nearing the Federal
Reserve's statutory goals of maximum employment and price stability, this conference
provides a timely opportunity to consider how the lessons we learned are likely to influence
the conduct of monetary policy in the future.
The theme of the conference, "Designing Resilient Monetary Policy Frameworks for the
Future," encompasses many aspects of monetary policy, from the nitty-gritty details of
implementing policy in financial markets to broader questions about how policy affects the
economy. Within the operational realm, key choices include the selection of policy
instruments, the specific markets in which the central bank participates, and the size and
structure of the central bank's balance sheet. These topics are of great importance to the
Federal Reserve. As noted in the minutes of last month's Federal Open Market Committee
(FOMC) meeting, we are studying many issues related to policy implementation, research
which ultimately will inform the FOMC's views on how to most effectively conduct monetary
policy in the years ahead. I expect that the work discussed at this conference will make
valuable contributions to the understanding of many of these important issues.
My focus today will be the policy tools that are needed to ensure that we have a resilient
monetary policy framework. In particular, I will focus on whether our existing tools are
adequate to respond to future economic downturns. As I will argue, one lesson from the
crisis is that our pre-crisis toolkit was inadequate to address the range of economic
circumstances that we faced. Looking ahead, we will likely need to retain many of the
monetary policy tools that were developed to promote recovery from the crisis. In addition,
policymakers inside and outside the Fed may wish at some point to consider additional
options to secure a strong and resilient economy. But before I turn to these longer-run
issues, I would like to offer a few remarks on the near-term outlook for the U.S. economy and
the potential implications for monetary policy.
Current economic situation and outlook
U.S. economic activity continues to expand, led by solid growth in household spending. But
business investment remains soft and subdued foreign demand and the appreciation of the
dollar since mid-2014 continue to restrain exports. While economic growth has not been
rapid, it has been sufficient to generate further improvement in the labor market. Smoothing
through the monthly ups and downs, job gains averaged 190,000 per month over the past
three months. Although the unemployment rate has remained fairly steady this year, near
5 percent, broader measures of labor utilization have improved. Inflation has continued to run
below the FOMC's objective of 2 percent, reflecting in part the transitory effects of earlier
declines in energy and import prices.
Looking ahead, the FOMC expects moderate growth in real gross domestic product (GDP),
additional strengthening in the labor market, and inflation rising to 2 percent over the next
few years. Based on this economic outlook, the FOMC continues to anticipate that gradual
increases in the federal funds rate will be appropriate over time to achieve and sustain
employment and inflation near our statutory objectives. Indeed, in light of the continued solid
performance of the labor market and our outlook for economic activity and inflation, I believe
the case for an increase in the federal funds rate has strengthened in recent months. Of
course, our decisions always depend on the degree to which incoming data continues to
confirm the Committee's outlook.
And, as ever, the economic outlook is uncertain, and so monetary policy is not on a preset
course. Our ability to predict how the federal funds rate will evolve over time is quite limited
because monetary policy will need to respond to whatever disturbances may buffet the
economy. In addition, the level of short-term interest rates consistent with the dual mandate
varies over time in response to shifts in underlying economic conditions that are often evident
only in hindsight. For these reasons, the range of reasonably likely outcomes for the federal
funds rate is quite wide - a point illustrated by figure 1 in your handout. The line in the center
is the median path for the federal funds rate based on the FOMC's Summary of Economic
Projections in June.1 The shaded region, which is based on the historical accuracy of private
and government forecasters, shows a 70 percent probability that the federal funds rate will
be between 0 and 3-1/4 percent at the end of next year and between 0 and 4-1/2 percent at
the end of 2018.2 The reason for the wide range is that the economy is frequently buffeted by
shocks and thus rarely evolves as predicted. When shocks occur and the economic outlook
changes, monetary policy needs to adjust. What we do know, however, is that we want a
policy toolkit that will allow us to respond to a wide range of possible conditions.
The pre-crisis toolkit
Prior to the financial crisis, the Federal Reserve's monetary policy toolkit was simple but
effective in the circumstances that then prevailed. Our main tool consisted of open market
operations to manage the amount of reserve balances available to the banking sector.3
These operations, in turn, influenced the interest rate in the federal funds market, where
banks experiencing reserve shortfalls could borrow from banks with excess reserves. Before
the onset of the crisis, the volume of reserves was generally small - only about $45 billion or
so.4 Thus, even small open market operations could have a significant effect on the federal
funds rate. Changes in the federal funds rate would then be transmitted to other short-term
interest rates, affecting longer-term interest rates and overall financial conditions and hence
inflation and economic activity. This simple, light-touch system allowed the Federal Reserve
to operate with a relatively small balance sheet - less than $1 trillion before the crisis - the
1
The June 2016 Summary of Economic Projections (SEP) is an addendum to the minutes of the
June 2016 FOMC meeting and is available on the Board's website at
www.federalreserve.gov/monetarypolicy/files/fomcminutes20160615.pdf.
2
The confidence interval equals (subject to a lower bound of 12.5 basis points) the median SEP path for the
federal funds rate plus or minus average root mean squared prediction errors (RMSPEs) of the three-month
Treasury bill rate, for horizons from zero to nine quarters ahead, based on forecast errors made over the past
20 years. Average RMSPEs are calculated as the mean of the RMSPEs of the following forecasters, subject
to availability for the horizon in question: the Federal Reserve Board staff (Greenbook/Tealbook), the
Administration, the Congressional Budget Office, the Blue Chip consensus forecast, and the Survey of
Professional Forecasters. Differences in predictive accuracy among these forecasters are not statistically
significant. For more information on the general methodology used to construct confidence intervals using
historical forecasting errors, see David Reifschneider and Peter Tulip (2007), "Gauging the Uncertainty of the
Economic Outlook from Historical Forecasting Errors (PDF)," Finance and Economics Discussion Series
2007-60 (Washington: Board of Governors of the Federal Reserve System, November).
3
Open market operations at the time were primarily repurchase agreements based on Treasury securities, with
primary dealers as counterparties.
4
Reserves of depository institutions include vault cash and balances maintained with Federal Reserve Banks.
Excess reserves are the reserves held over and above required reserves. See the Board's webpage "Reserve
Requirements" at www.federalreserve.gov/monetarypolicy/reservereq.htm.
size of which was largely determined by the need to supply enough U.S. currency to meet
demand.5
The global financial crisis revealed two main shortcomings of this simple toolkit. The first was
an inability to control the federal funds rate once reserves were no longer relatively scarce.
Starting in late 2007, faced with acute financial market distress, the Federal Reserve created
programs to keep credit flowing to households and businesses.6 The loans extended under
those programs helped stabilize the financial system. But the additional reserves created by
these programs, if left unchecked, would have pushed down the federal funds rate, driving it
well below the FOMC's target. To prevent such an outcome, the Federal Reserve took
several steps to offset (or sterilize) the effect of its liquidity and credit operations on
reserves.7 By the fall of 2008, however, the reserve effects of our liquidity and credit
programs threatened to become too large to sterilize via asset sales and other existing tools.
Without sufficient sterilization capacity, the quantity of reserves increased to a point that the
Federal Reserve had difficulty maintaining effective control over the federal funds rate.
Of course, by the end of 2008, stabilizing the federal funds rate at a level materially above
zero was not an immediate concern because the economy clearly needed very low
shortterm interest rates. Faced with a steep rise in unemployment and declining inflation, the
FOMC lowered its target for the federal funds rate to near zero, a reduction of roughly
5 percentage points over the previous year and a half. Nonetheless, a variety of policy
benchmarks would, at least in hindsight, have called for pushing the federal funds rate well
below zero during the economic downturn.8 That doing so was impossible highlights the
second serious limitation of our pre-crisis policy toolkit: its inability to generate substantially
more accommodation than could be provided by a near-zero federal funds rate.
5
Prior to the financial crisis, the size of the Fed's balance sheet was about $900 billion. Assets consisted
almost entirely of Treasury securities. Liabilities included currency held by the public and a relatively
small volume of reserve balances. For more on the Fed's balance sheet, see
www.federalreserve.gov/monetarypolicy/bst_fedsbalancesheet.htm.
6
For information on the Federal Reserve's credit and liquidity programs that were implemented in response to
the financial crisis, see www.federalreserve.gov/monetarypolicy/bst_crisisresponse.htm on the Board's
website.
7
Reserves were initially taken out of the banking system by not reinvesting principal payments from maturing
securities and later by selling portions of securities holdings. In September 2008, the Department of the
Treasury announced the temporary Supplementary Financing Program, in which the proceeds of a series of
Treasury bill auctions, separate from Treasury's routine borrowing, were maintained in an account at the
Federal Reserve Bank of New York. The funds in this account served to drain reserves from the banking
system.
8
Consider the following policy rule: R(t) = R* + p(t) + 0.5[p(t)-p*]-2.0[U(t)-U*], where R is the federal funds rate,
R* is the longer-run normal value of the federal funds rate adjusted for inflation, p is the four-quarter moving
average of core PCE inflation, p* is the FOMC's target for inflation (2 percent), U is the unemployment rate,
and U* is the longer-run normal rate of unemployment. Based on the medians of FOMC participants' latest
longer-run projections, R* is approximately 1 percent and U* is about 4.8 percent. Accordingly, with the
unemployment rate climbing to 10 percent and core PCE inflation falling to 1 percent in 2009, this rule would
have prescribed lowering the federal funds rate to minus 9 percent at the depths of the recession. In contrast,
the standard Taylor rule, which is half as responsive to movements in resource utilization, would have
prescribed lowering the federal funds rate to minus 3-3/4 percent using the same estimates for R* and U*. The
more aggressive rule does a reasonably good job of accounting for movements in the federal funds rate in the
decade prior to its falling to its effective lower bound in late 2008, see David Reifschneider (2016), "Gauging
the Ability of the FOMC to Respond to Future Recessions (PDF)," Finance and Economics Discussion Series
2016-068 (Washington: Board of Governors of the Federal Reserve System, August). For more information
on the standard Taylor rule, see John B. Taylor (1993), "Discretion versus Policy Rules in Practice,"
CarnegieRochester Conference Series on Public Policy, vol. 39 (December), pp. 195-214.
Our expanded toolkit
To address the challenges posed by the financial crisis and the subsequent severe recession
and slow recovery, the Federal Reserve significantly expanded its monetary policy toolkit. In
2006, the Congress had approved plans to allow the Fed, beginning in 2011, to pay interest
on banks' reserve balances.9 In the fall of 2008, the Congress moved up the effective date of
this authority to October 2008. That authority was essential. Paying interest on reserve
balances enables the Fed to break the strong link between the quantity of reserves and the
level of the federal funds rate and, in turn, allows the Federal Reserve to control short-term
interest rates when reserves are plentiful. In particular, once economic conditions warrant a
higher level for market interest rates, the Federal Reserve could raise the interest rate paid
on excess reserves - the IOER rate. A higher IOER rate encourages banks to raise the
interest rates they charge, putting upward pressure on market interest rates regardless of the
level of reserves in the banking sector.
While adjusting the IOER rate is an effective way to move market interest rates when
reserves are plentiful, federal funds have generally traded below this rate. This relative
softness of the federal funds rate reflects, in part, the fact that only depository institutions can
earn the IOER rate. To put a more effective floor under short-term interest rates, the Federal
Reserve created supplementary tools to be used as needed. For instance, the overnight
reverse repurchase agreement (ON RRP) facility is available to a variety of counterparties,
including eligible money market funds, government-sponsored enterprises, broker-dealers,
and depository institutions. Through it, eligible counterparties may invest funds overnight with
the Federal Reserve at a rate determined by the FOMC. Similar to the payment of IOER, the
ON RRP facility discourages participating institutions from lending at a rate substantially
below that offered by the Fed.10
Our current toolkit proved effective last December. In an environment of superabundant
reserves, the FOMC raised the effective federal funds rate - that is, the weighted average
rate on federal funds transactions among participants in that market - by the desired amount,
and we have since maintained the federal funds rate in its target range.
Two other major additions to the Fed's toolkit were large-scale asset purchases and
increasingly explicit forward guidance.11 Both were used to provide additional monetary
policy accommodation after short-term interest rates fell close to zero. Our purchases of
Treasury and mortgage-related securities in the open market pushed down longer-term
borrowing rates for millions of American families and businesses. Extended forward rate
guidance - announcing that we intended to keep short-term interest rates lower for longer
than might have otherwise been expected - also put significant downward pressure on
longer-term borrowing rates, as did guidance regarding the size and scope of our asset
purchases.
In light of the slowness of the economic recovery, some have questioned the effectiveness of
asset purchases and extended forward rate guidance. But this criticism fails to consider the
unusual headwinds the economy faced after the crisis. Those headwinds included
substantial household and business deleveraging, unfavorable demand shocks from abroad,
a period of contractionary fiscal policy, and unusually tight credit, especially for housing.
Studies have found that our asset purchases and extended forward rate guidance put
appreciable downward pressure on long-term interest rates and, as a result, helped spur
growth in demand for goods and services, lower the unemployment rate, and prevent
inflation from falling further below our 2 percent objective.12
Two of the Fed's most important new tools - our authority to pay interest on excess reserves
and our asset purchases - interacted importantly. Without IOER authority, the Federal
Reserve would have been reluctant to buy as many assets as it did because of the
longerrun implications for controlling the stance of monetary policy. While we were buying assets
aggressively to help bring the U.S. economy out of a severe recession, we also had to keep
in mind whether and how we would be able to remove monetary policy accommodation when
appropriate. That issue was particularly relevant because we fund our asset purchases
through the creation of reserves, and those additional reserves would have made it ever
more difficult for the pre-crisis toolkit to raise short-term interest rates when needed.
The FOMC considered removing accommodation by first reducing our asset holdings
(including through asset sales) and raising the federal funds rate only after our balance sheet
had contracted substantially. But we decided against this approach because our ability to
predict the effects of changes in the balance sheet on the economy is less than that
associated with changes in the federal funds rate. Excessive inflationary pressures could
arise if assets were sold too slowly. Conversely, financial markets and the economy could
potentially be destabilized if assets were sold too aggressively. Indeed, the so-called taper
tantrum of 2013 illustrates the difficulty of predicting financial market reactions to
announcements about the balance sheet. Given the uncertainty and potential costs
associated with large-scale asset sales, the FOMC instead decided to begin removing
monetary policy accommodation primarily by adjusting short-term interest rates rather than
by actively managing its asset holdings.13 That strategy - raising short-term interest rates
once the recovery was sufficiently advanced while maintaining a relatively large balance
sheet and plentiful bank reserves - depended on our ability to pay interest on excess
reserves.
Where do we go from here?
What does the future hold for the Fed's toolkit? For starters, our ability to use interest on
reserves is likely to play a key role for years to come. In part, this reflects the outlook for our
balance sheet over the next few years. As the FOMC has noted in its recent statements, at
some point after the process of raising the federal funds rate is well under way, we will cease
or phase out reinvesting repayments of principal from our securities holdings. Once we stop
reinvestment, it should take several years for our asset holdings - and the bank reserves
used to finance them - to passively decline to a more normal level. But even after the volume
of reserves falls substantially, IOER will still be important as a contingency tool, because we
12
See, for instance, Joseph Gagnon, Matthew Raskin, Julie Remache, and Brian Sack (2011), "The Financial
Market Effects of the Federal Reserve's Large-Scale Asset Purchases," International Journal of Central
Banking, vol. 7 (March), pp. 3-43; and Stefania D'Amico, William English, David López-Salido, and Edward
Nelson (2012), "The Federal Reserve's Large-Scale Asset Purchase Programmes: Rationale and Effects,"
Economic Journal, vol. 122 (November), pp. F415-46. Moreover, the Federal Reserve's forward guidance and
asset purchase policies have been estimated to have helped lower unemployment and boost inflation; see
Eric M. Engen, Thomas Laubach, and David Reifschneider (2015), "The Macroeconomic Effects of the
Federal Reserve's Unconventional Monetary Policies," Finance and Economics Discussion Series 2015-005
(Washington: Board of Governors of the Federal Reserve System, January).
13
The FOMC's "Policy Normalization Principles and Plans" call for reducing the Federal Reserve's securities
holdings in a "gradual and predictable manner primarily by ceasing to reinvest repayments of principal on
securities held in the [System Open Market Account]" (Board of Governors of the Federal Reserve System
(2014), "Federal Reserve Issues FOMC Statement on Policy Normalization Principles and Plans," press
release, September 17, second bullet). Consistent with those plans, the Federal Open Market Committee
anticipates that it will maintain its current reinvestment strategy "until normalization of the level of the federal
funds rate is well under way" (for instance, see Board of Governors of the Federal Reserve System (2015),
"Federal Reserve Issues FOMC Statement," press release, December 16, paragraph 5.
may need to purchase assets during future recessions to supplement conventional interest
rate reductions.14 Forecasts now show the federal funds rate settling at about 3 percent in
the longer run.15 In contrast, the federal funds rate averaged more than 7 percent between
1965 and 2000. Thus, we expect to have less scope for interest rate cuts than we have had
historically.
In part, current expectations for a low future federal funds rate reflect the FOMC's success in
stabilizing inflation at around 2 percent - a rate much lower than rates that prevailed during
the 1970s and 1980s. Another key factor is the marked decline over the past decade, both
here and abroad, in the long-run neutral real rate of interest - that is, the inflation-adjusted
short-term interest rate consistent with keeping output at its potential on average over time.16
Several developments could have contributed to this apparent decline, including slower
growth in the working-age populations of many countries, smaller productivity gains in the
advanced economies, a decreased propensity to spend in the wake of the financial crises
around the world since the late 1990s, and perhaps a paucity of attractive capital projects
worldwide.17 Although these factors may help explain why bond yields have fallen to such
low levels here and abroad, our understanding of the forces driving long-run trends in interest
rates is nevertheless limited, and thus all predictions in this area are highly uncertain.18
Would an average federal funds rate of about 3 percent impair the Fed's ability to fight
recessions? Based on the FOMC's behavior in past recessions, one might think that such a
14
If the FOMC were to again increase the size of the balance sheet markedly in response to a future recession,
then the ability to pay interest on reserves could be critical during the subsequent recovery period to help
control short-term interest rates while the balance sheet remains elevated. Beyond this motivation for retaining
IOER, the ability to pay interest on reserves could also be important to the operation of any special liquidity
and credit facilities that might be created to deal with systemic disruptions to the financial system during a
future emergency. In particular, such facilities could significantly expand the supply of reserves, which would
be problematic if the FOMC wished to keep short-term interest rates from falling to zero.
15
In the Blue Chip Financial Indicators survey released on June 1, 2016, the consensus forecast for the
longer-run level of the federal funds rate was 3.2 percent. FOMC participants in June 2016
generally anticipated a slightly lower longer-run level, in that the median of their individual
forecasts was 3 percent (see table 1 of the June 2016 SEP, available at
www.federalreserve.gov/monetarypolicy/fomcminutes20160615ep.htm). The latest long-run forecast from the
Administration (www.whitehouse.gov/sites/default/files/omb/budget/fy2016/assets/16msr.pdf) is also close to
3 percent, as was the projection made by the Congressional Budget Office earlier in the year (see
www.cbo.gov/about/products/budget_economic_data).
16
Updated estimates from the model developed by Laubach and Williams (2003) indicate that the real long-run
neutral or "equilibrium" short-term interest rate in the United States is currently about 2-1/2 percentage points
lower than it was on average in the 1980s and 1990s (see Thomas Laubach and John C. Williams (2003),
"Measuring the Natural Rate of Interest," Review of Economics and Statistics, vol. 85 (November),
pp. 1063-70; updated estimates are available at
www.frbsf.org/economic-research/economists/johnwilliams/Laubach_Williams_updated_estimates.xlsx.). In addition, Holston, Laubach, and Williams (2016) find
significant but somewhat smaller declines in equilibrium rates for the euro area, Canada, and the United
Kingdom (see Kathryn Holston, Thomas Laubach, and John C. Williams (2016), "Measuring the Natural Rate
of Interest: International Trends and Determinants," Working Paper 2016-11 (San Francisco: Federal Reserve
Bank of San Francisco, June), www.frbsf.org/economic-research/files/wp2016-11.pdf).
17
For a discussion of the possible role played by these factors in explaining the current low level of interest rates
in the United States and other advanced economies, see Lawrence H. Summers (2014), "U.S. Economic
Prospects: Secular Stagnation, Hysteresis, and the Zero Lower Bound," Business Economics, vol. 49 (April),
pp. 65-73; Robert J. Gordon (2014), "The Demise of U.S. Economic Growth: Restatement, Rebuttal, and
Reflections," NBER Working Paper 19895 (Cambridge, Mass.: National Bureau of Economic Research,
February); and Ben S. Bernanke (2015), "Why Are Interest Rates So Low, Part 2: Secular Stagnation," Ben
Bernanke's Blog, blog post (Washington: Brookings Institution, March 31).
18
For example, see James D. Hamilton, Ethan S. Harris, Jan Hatzius, and Kenneth D. West (2015), "The
Equilibrium Real Funds Rate: Past, Present, and Future," NBER Working Paper 21476 (Cambridge, Mass.:
National Bureau of Economic Research, August); and Olivier Blanchard (2016), "Three Remarks on the U.S.
Treasury Yield Curve," Realtime Economic Issues Watch (Washington: Peterson Institute for International
Economics, June 22).
low interest rate could substantially impair policy effectiveness. As shown in the first column
of the table in the handout, during the past nine recessions, the FOMC cut the federal funds
rate by amounts ranging from about 3 percentage points to more than 10 percentage points.
On average, the FOMC reduced rates by about 5-1/2 percentage points, which seems to
suggest that the FOMC would face a shortfall of about 2-1/2 percentage points for dealing
with an average-sized recession. But this simple comparison exaggerates the limitations on
policy created by the zero lower bound. As shown in the second column, the federal funds
rate at the start of the past seven recessions was appreciably above the level consistent with
the economy operating at potential in the longer run. In most cases, this tighter-than-normal
stance of policy before the recession appears to have reflected some combination of initially
higher-than-normal labor utilization and elevated inflation pressures. As a result, a large
portion of the rate cuts that subsequently occurred during these recessions represented the
undoing of the earlier tight stance of monetary policy. Of course, this situation could occur
again in the future. But if it did, the federal funds rate at the onset of the recession would be
well above its normal level, and the FOMC would be able to cut short-term interest rates by
substantially more than 3 percentage points.
A recent paper takes a different approach to assessing the FOMC's ability to respond to
future recessions by using simulations of the FRB/US model.19 This analysis begins by
asking how the economy would respond to a set of highly adverse shocks if policymakers
followed a fairly aggressive policy rule, hypothetically assuming that they can cut the federal
funds rate without limit.20 It then imposes the zero lower bound and asks whether some
combination of forward guidance and asset purchases would be sufficient to generate
economic conditions at least as good as those that occur under the hypothetical
unconstrained policy. In general, the study concludes that, even if the average level of the
federal funds rate in the future is only 3 percent, these new tools should be sufficient unless
the recession were to be unusually severe and persistent.
Figure 2 in your handout illustrates this point. It shows simulated paths for interest rates, the
unemployment rate, and inflation under three different monetary policy responses - the
aggressive rule in the absence of the zero lower bound constraint, the constrained
aggressive rule, and the constrained aggressive rule combined with $2 trillion in asset
purchases and guidance that the federal funds rate will depart from the rule by staying lower
for longer.21 As the blue dashed line shows, the federal funds rate would fall far below zero if
19
FRB/US model simulations have several advantages for analyzing this issue. For one, the model's structure
allows the public's expectations for interest rates, inflation, and other factors to take full account of the
implications of the effective lower bound on nominal interest rates, changes in future monetary policy as
signaled by forward guidance, and asset purchases. In addition, the model incorporates the low
responsiveness of inflation to movements in resource utilization seen in recent years as well as the effects of
asset purchases on term premiums, and thus a variety of longer-term interest rates, equity prices, and the
foreign exchange value of the dollar. For a further discussion about the advantages (and possible
disadvantages) of using the FRB/US model to study this issue, see Reifschneider, "Gauging the Ability of the
FOMC to Respond to Future Recessions," in note 8.
20
The aggressive rule is R(t) = 1.0 + p(t) + 0.5 [p(t)-2] - 2.0 [4.8 - U(t)], where R is the federal funds rate, p is
the four-quarter moving average of core PCE inflation, and U is the unemployment rate. Note that baseline
values of the equilibrium real rate, the natural rate of unemployment, and the target rate of inflation used in the
simulation analysis - 1.0 percent, 4.8 percent, and 2.0 percent, respectively - are consistent with the medians
of the latest long-run projections of individual FOMC participants. As discussed by Taylor (1999), this rule
appears to do a good job in stabilizing real activity and inflation in a wide range of economic models (see John
B. Taylor (1999), "Introduction," in John B. Taylor, ed., Monetary Policy Rules (Chicago: University of Chicago
Press), pp. 1-14).
21
The forward guidance is provided at the start of the recession and has three components. First, the federal
funds rate will be lowered to zero more quickly than prescribed by the rule. Second, the federal funds rate will
remain at zero as long as the unemployment rate is greater than 5 percent. And, finally, that after the initial
increase in the federal funds rate, policymakers will proceed gradually in returning to the prescriptions of the
policy rule.
policy were unconstrained, thereby causing long-term interest rates to fall sharply. But
despite the lower bound, asset purchases and forward guidance can push long-term interest
rates even lower on average than in the unconstrained case (especially when adjusted for
inflation) by reducing term premiums and increasing the downward pressure on the expected
average value of future short-term interest rates. Thus, the use of such tools could result in
even better outcomes for unemployment and inflation on average.
Of course, this analysis could be too optimistic. For one, the FRB/US simulations may
overstate the effectiveness of forward guidance and asset purchases, particularly in an
environment where long-term interest rates are also likely to be unusually low.22 In addition,
policymakers could have less ability to cut short-term interest rates in the future than the
simulations assume. By some calculations, the real neutral rate is currently close to zer