Must-Read: Michael T. Kiley and John M. Roberts: Monetary policy in a Low Interest Rate World

Must-Read: Back in 1992 Larry Summers and I warned that, *even with business cycles of the size seen in the “Great Moderation” era, trying to reduce inflation much below 5%/year was a risky and dangerous endeavor. Since they we have learned that the world can give us—from causes that seem trivial as a share of world asset stocks—shocks much larger than was thought reasonable in the “Great Moderation” era, plus we have had a very sharp and apparently permanent fall in real interest rates. That has changed the 2%/year inflation target from being risky and dangerous to being… simply not sane…

Michael T. Kiley and John M. Roberts: Monetary policy in a Low Interest Rate World: “Nominal interest rates may remain substantially below the averages of the last half-century…

…Persistently low nominal interest rates may lead to more frequent and costly episodes at the effective lower bound (ELB) on nominal interest rates…. Monetary policy strategies based on traditional simple policy rules lead to poor economic performance when the equilibrium real interest rate is low, with economic activity and inflation more volatile and systematically falling short of desirable levels. Moreover, the frequency and length of ELB episodes under such policy approaches is estimated to be significantly higher…. A risk-adjustment to a simple rule in which monetary policymakers are more accommodative, on average, than prescribed by the rule ensures that inflation averages its 2 percent objective–and requires that policymakers systematically seek inflation near 3 percent when the ELB is not binding…. Commitment strategies in which monetary accommodation is not removed until either inflation or economic activity overshoot their long-run objectives are very effective in both the DSGE and FRB/US model. Finally, raising the inflation target above 2 percent can mitigate the deterioration in economic performance…