Conducting Monetary Policy at Very Low Short-Term Interest Rates

Can monetary policy committees, accustomed to describing their plans and actions in terms of the level of a short-term nominal interest rate, find effective means of conducting and communicating their policies when that rate is zero or close to zero? The very low levels of interest rates in Japan, Switzerland, and the United States in recent years have stimulated much interesting research on this question and have led some central banks to make changes in their operating procedures and communications strategies. In this paper, we will give a brief overview of current thinking on the conduct of monetary policy when short-term interest rates are very low or even zero. Monetary policy works for the most part by influencing the prices and yields of financial assets, which in turn affect economic decisions and thus the evolution of the economy. When the short-term policy rate is at or near zero, the conventional means of effecting monetary ease (lowering the target for the policy rate) is no longer feasible. However, it would be a mistake to think that monetary policy was impotent. We discuss three strategies for stimulating the economy at an unchanged level of the policy rate: these involve (i) providing assurance to investors that short rates will be kept lower in the future than they currently expect, (ii) changing the relative supplies of securities in the marketplace by altering the composition of the central bank’s balance sheet, and (iii) increasing the size of the central bank’s balance sheet beyond the level needed to set the short-term policy rate at zero (“quantitative easing”). We also discuss the costs and benefits of very low interest rates, an issue that bears on the question of whether the central bank should take the policy rate all the way to zero before undertaking alternative policies.