lael brainard : normalizing monetary policy when the neutral interest rate is low speech by ms lael brainard, member of the board of governors of the federal reserve system, at the stanford institute for economic policy research, stanford, california, 1 december 2015. * * * let me begin by noting that my comments today will not address the timing of liftoff for the federal funds rate. 1 recent months have seen increased anticipation of the normalization of monetary policy in the united states. many observers interpret normalization to mean a tightening cycle similar in pace to previous cycles, such as those from 1994 to 1995 and from 2004 to 2007, with the effect of returning interest rates to the level viewed as normal in the decades before the crisis. the federal reserve describes normalization as " steps to raise the federal funds rate and other short - term interest rates to more normal levels. " 2 but what do we mean by " more normal levels "? a broad deterioration in foreign growth prospects, together with greater risk sensitivity in the wake of the crisis and changes in the rate of potential output growth, may be contributing to a " new normal. " the new normal is likely to be characterized by a lower level of interest rates than in the decades preceding the crisis, which counsels a cautious and gradual approach to adjusting monetary policy. the benchmark neutral rate the appropriate pace and target for normalizing monetary policy depend centrally on understanding the neutral rate of interest. the nominal neutral interest rate is the level of the federal funds rate that is consistent with output growing close to its potential rate with full employment and stable inflation. 3 the appropriate benchmark for assessing the stance of monetary policy is the gap between the policy rate and the nominal neutral rate of interest : when the federal funds rate is below the nominal neutral rate, monetary policy is accommodative, and, when it is above the neutral rate, policy is contractionary. for this reason, many monetary policy rules, such as the well - known taylor rule, incorporate an estimate of the neutral real interest rate as a critical parameter along with the target rate of inflation. 4 although the neutral rate is a critical benchmark for monetary policy, it changes over time in response to important changes in economic conditions, necessitating corresponding adjustments in monetary policy in order to restore the economy to full employment. for instance, when there are modest adverse shocks to demand that lead to modest reductions in the shorter - run neutral rate, monetary policy can provide enough support to keep the

a major financial crisis, which the federal reserve addressed through a large amount of broad - based lending. the decrease in net worth led to a major recession and ongoing slow recovery. the federal reserve ’ s reduction in interest rates has lessened the impact of this change in net worth. see kocherlakota ( 2010 ) for a more extensive discussion of the relevant transmission mechanisms. bis central bankers ’ speeches looking back over the past four years : outcomes how has the federal reserve performed relative to its dual mandate over the past four years, since the onset of the great recession at the end of 2007? in terms of price stability, the answer is remarkably well. the personal consumption expenditure ( pce ) inflation rate has averaged 1. 8 percent per year from the fourth quarter of 2007 through the third quarter of 2011. in my view, this outcome is essentially consistent with price stability. now, i want to be clear here about what i mean when i say “ inflation ”. that number i just gave you, 1. 8 percent per year for nearly four years, refers to what ’ s termed headline inflation. it includes all goods and services, including food and energy. when the fed says that it is committed to keeping inflation at 2 percent or a little less, it means prices for all goods and services, including the gas we put in our cars and the food we put on our tables. when we make reference to year - over - year core inflation – that is, inflation without food and energy – it ’ s only because we believe that core inflation is a helpful predictor of headline inflation over the next three or four years. it is important, i think, to understand why there is no longer an intrinsic connection between the size of the fed ’ s balance sheet and inflation. in the past three years, the fed has bought over $ 2 trillion of securities issued or backed by the government. the fed has funded that purchase by tripling the amount of deposits held by banks with the fed – what are called bank reserves. the standard reasoning is that this kind of reserve creation is inflationary. banks are only allowed to offer checkable deposits in proportion to their reserves. economists view checkable deposits as a form of money because, like cash, checkable deposits make many transactions easier. in this sense, bank reserves held with the fed are essentially licenses for banks to create a certain amount of money. by giving out more licenses, the fomc is allowing banks to create more money. and if