. market - based measures of inflation compensation at longer - term horizons, such as inflation swaps and the difference between nominal and inflation - indexed treasury bond yields, have declined more noticeably over the past year and a half. although it is difficult to precisely disentangle the contribution of changes in inflation expectations, liquidity premiums, and inflation risk premiums to this downward shift, some decompositions suggest that, while expected inflation may not have declined much, market participants may be placing a somewhat greater likelihood than previously on episodes of below - potential growth being accompanied by below - target inflation. thus, the decline in measures of inflation expectations warrants close monitoring. the slow progress on inflation, together with the likely low level of the longer - term neutral real rate and the slow pace at which the very low shorter - term rate may move to the longer - term rate, suggest that the federal funds rate is likely to adjust more gradually and to a lower level than in previous expansions. in short, " gradual and low " is likely to be the new normal. in addition, the combination of a low neutral real rate with slow progress on inflation suggests a greater likelihood of hitting the zero lower bound than in previous decades, when the neutral rate was probably much higher. the lower the longer - term nominal neutral rate is, the smaller in magnitude an adverse economic shock must be to push growth sufficiently below potential to necessitate a nominal federal funds rate below zero to provide accommodation. assuming there has not been a material reduction in the frequency and severity of negative shocks since the pre - crisis period, the implication is that the probability of being constrained by the zero lower bound is greater than prior to the crisis. although empirical analysis suggests that unconventional tools affect the economy through the same channels as the federal funds rate, even so, there are greater costs and uncertainties associated with unconventional policies relative to changes in the federal funds rate. 16as a result, policy is likely to remain more constrained at the zero lower bound than above it. as the probability of hitting the zero lower bound increases, the asymmetry in policy flexibility becomes more pronounced. because we have more space to respond by raising rates if inflationary forces accelerate than by cutting rates if disinflationary forces emerge, when nominal neutral rates are likely to be lower on average, we should be cautious about raising rates, do so gradually, and carefully assess the effects on economic and financial conditions see engen, laubach and reifschneider (

more and more funds from capital accumulation. once this process begins, market psychology may hasten the adjustment. 11 hence, while natural forces lessen the basic external imbalance, they increase the basic budget imbalance. in the long run, the only way to correct budget deficits is for policymakers to correct them. outside forces there are several outside forces - both natural and as a result of policy - that could influence budget and trade deficits. one generally helpful influence is productivity growth. say the u. s. economy benefits from an exogenous positive shock to productivity growth, as it seemed to have in the late 1990s. this shock would raise the trend path of income, meaning that slightly higher primary budget and trade deficits could still be consistent with debt - to - gdp stability ; in effect, a higher level of g can be plugged into equation 2 ( at least as long as it is not offset by a higher i ). higher productivity could also help lengthen the credibility range, the range in which moderate changes in the debt ratio might not lead to adverse changes in relative prices. among other things, higher productivity could raise the marginal product of capital and make investment in u. s. assets relatively attractive. but even with these favorable developments, the stability conditions discussed above still hold. if they are violated, the natural adjustment mechanisms will eventually take over for the trade deficit, and the primary budget deficit will eventually have to be reduced to stop a growing government debt ratio. one unhelpful measure is trade protectionism. while it might appear that trade protectionism would correct trade deficits, it probably will not. over the medium and long run, the economy should be producing near its natural growth path, perhaps because of timely monetary and / or fiscal policy, perhaps because of natural equilibrating forces in the economy. in this event, trade protectionism would not stimulate added national production. even if protectionist measures reduce imports, the added spending demands for import - competing industries will crowd out other types of production. put another way, equation 1 shows that the trade deficit is ultimately determined by national saving and investment. without a change in these, protectionism merely shifts the types of goods that are produced. it does not increase overall production and, short of cutting off trade altogether, does not even change the trade balance. moreover, as is well known, over the long run, trade protection lowers a nation ’ s standard of living. this view is given in michael doo