To avoid that mistake today, under the structural impediments scenario, the Fed should revert to a “business-as-usual” monetary policy and begin to consider removing excess accommodation before inflation rises above its target and inflation expectations start to creep unalterably upward. There is a second competing storyline – one that I refer to as the “liquidity trap scenario”. First, consider what occurs during normal times when nominal rates of interest are considerably above zero and real rates of interest are positive. If the supply of savings increased but the demand for investment remained unchanged, market forces would drive down real interest rates to some natural rate of interest that equilibrates savings and investment. This market dynamic is thwarted in the case of a liquidity trap. Here, cautious behavior holding back spending – whether it is due to risk aversion, extreme patience or deleveraging – causes the supply of savings to exceed the demand for investment even at very low interest rates. Today short-term, risk-free interest rates are close to zero and actual real rates are only modestly negative. But they are still not low enough – because short-term nominal interest rates cannot fall below zero, real rates cannot become negative enough to equilibrate savings and investment. As I weigh the evidence, I find the case for the liquidity trap scenario more compelling than one for the structural impediments scenario. My assessment has been influenced by the book titled This Time Is Different: Eight Centuries of Financial Folly3 by Carmen Reinhart and Kenneth Rogoff.

In such an adverse situation, the inflation safeguard triggers an exit from the now-evident excessive policy accommodation before inflation expectations become unhinged. We would not have the desired reductions in unemployment, but then again, there wouldn’t be anything that monetary policy could do about it. We would suffer some policy loss in that a 3 percent inflation rate is above our 2 percent target. But we certainly have experienced inflation rates near 3 percent in the recent past and have weathered them well. And 3 percent won’t unhinge long-run inflation expectations. We are not talking about anything close to the debilitating higher inflation rates we saw in the 1970s or 1980s. We would also know that we had made our best effort. Conclusion Today, I have outlined an appropriate course for monetary policy to take when we cannot know with certainty the degrees to which various forces are driving the economic weakness we currently face. If, as I fear, the liquidity trap scenario describes the present environment, we risk being mired in recession-like circumstances for an unacceptably long period. Indeed, each passing month of stagnation represents real economic losses that are borne by all. In addition, I worry that even when the economy does regain traction, its new potential growth path will be permanently impaired. The skills of the long-term unemployed may atrophy and incentives for workers to invest in acquiring new skills may be diminished. Similarly, businesses facing uncertain demand are less inclined to invest in new productive capacity and technologies.