It has been moving lower recently and is far lower than at any time in recent memory (Figure 15). While this pattern likely reflects in part a very low term premium, it may also be driven by an assessment that the equilibrium real rate has fallen and will remain unusually low for years. This evidence implies that current circumstances warrant the use of a significantly lower neutral real short-term rate in the Taylor Rule formulations. As economic conditions normalize, supported by accommodative monetary policy, the neutral interest rate presumably would gradually rise back toward its long run level over time. For example, adjusting Taylor 1999 for a zero percent neutral real rate that gradually normalizes over time would push liftoff beyond 2014 (Figure 16). Risk management considerations also suggest that a more stimulative monetary policy than prescribed by Taylor 1999 is appropriate. In particular, simple policy rules implicitly treat the welfare losses generated by deviations from the central forecast path symmetrically. But I don’t believe that the potential losses are currently symmetric. In my view, the distribution of potential outcomes is currently skewed to the downside, reflecting risks posed by developments in Europe and the impending U.S. fiscal cliff. Moreover, the costs associated with such downside outcomes are likely to be considerably higher than the costs of realizing upside surprises. For example, consider two alternative scenarios: an economy that grows very quickly, but starting with some genuine spare capacity, versus an economy operating way below potential that stagnates, pushing the United States into a liquidity trap.

  Although credit availability is improving, the sharp tightening that occurred in 2008 and 2009 has not fully reversed (Figure 13).   Credit availability remains unusually tight for certain sectors such as housing and small business.   The exchange value of the dollar remains in the middle of a long-run channel showing a gentle decline (Figure 14). 11  Or, if we were wrong about spare capacity, inflation should be higher. 12  See Thomas Laubach and John Williams, “Measuring the Natural Rate of Interest,” Review of Economics and Statistics, November 2003, pp.1063-1070. The link to the updated estimates is: http://www.frbsf.org/economics/economists/jwilliams/Laubach_Williams_updated_estimates.xls. 13  Impairment to the transmission mechanism implies that the neutral rate that neither stimulates nor slows the economy will be lower than it would otherwise be. BIS central bankers’ speeches  7  Similarly, there is evidence that the linkage between financial conditions and economic activity is attenuated as well. The most obvious example of this is the housing sector. But the subdued overall rate of credit expansion for both households and the business sector is also noteworthy. This has occurred despite a monetary policy that would be judged on its face as one of the most stimulative in history. Finally, market expectations suggest that the equilibrium real rate of interest will remain depressed. To me, it is particularly noteworthy that the real forward interest rate expected 5 to 10 years in the future is currently only 0.3 percent.