Discussion of “Limitations on the Effectiveness of Forward Guidance at the Zero Lower Bound”

What should the monetary authority do when prices are sticky? One answer to this question is provided by the standard New Keynesian model of sticky prices. It says that optimal monetary policy should fully stabilize the long-term price level in many environments. For example, if all fluctuations are in the “IS curve,” then the optimal monetary policy under commitment is simply for the short-term interest rate to mirror the “natural rate of interest” and maintain a strict policy of price-level constancy. Output is then maintained close to the “natural rate.” However, when the monetary authority faces a zero lower bound on the nominal interest rate, then the committed monetary authority faces a different set of trade-offs: as stressed by Eggertsson and Woodford (2003), it is typically optimal for the monetary authority to plan a temporary period of inflation. In this paper, Levin et al. (2009) (hereafter, LLNY) provide— among many other results—an important reminder that the optimal policy for the price level incorporates “base drift” whenever the zero lower bound is binding, with the long-run price level rising as a result of the inflation that is necessary as part of a desirable stabilization program. In my discussion, I lay out the basic mechanics of this result and explain why it is somewhat surprising vis-à-vis the “case for price stability” that is present in this class of models. I also relate the difference between these two policies to alternative monetary policy statements that might be issued by a monetary authority during a period of low interest rates so as to produce outcomes that are close to the optimal monetary policy under commitment.