Tying Down the Anchor: Monetary Policy Rules and the Lower Bound on Interest Rates

42 Pages Posted: 6 May 2019 Last revised: 17 Aug 2019

See all articles by Thomas M. Mertens

Thomas M. Mertens

Federal Reserve Bank of San Francisco

John C. Williams

Federal Reserve Bank of New York

Date Written: May 1, 2019

Abstract

This paper uses a standard New Keynesian model to analyze the effects and implementation of various monetary policy frameworks in the presence of a low natural rate of interest and a lower bound on interest rates. Under a standard inflation-targeting approach, inflation expectations will be anchored at a level below the inflation target, which in turn exacerbates the deleterious effects of the lower bound on the economy. Two key themes emerge from our analysis. First, the central bank can eliminate this problem of a downward bias in inflation expectations by following an average-inflation targeting framework that aims for above-target inflation during periods when policy is unconstrained. Second, dynamic strategies that raise inflation expectations by keeping interest rates “lower for longer” after periods of low inflation can both anchor expectations at the target level and further reduce the effects of the lower bound on the economy.

Keywords: monetary policy; inflation expectations; lower bound; inflation target

JEL Classification: E52

Suggested Citation

Mertens, Thomas M. and Williams, John C., Tying Down the Anchor: Monetary Policy Rules and the Lower Bound on Interest Rates (May 1, 2019). FRB of New York Staff Report No. 887 (2019), Available at SSRN: https://ssrn.com/abstract=3382525 or http://dx.doi.org/10.2139/ssrn.3382525

Thomas M. Mertens (Contact Author)

Federal Reserve Bank of San Francisco ( email )

101 Market Street
San Francisco, CA 94105
United States

John C. Williams

Federal Reserve Bank of New York ( email )

33 Liberty Street
New York, NY 10045
United States

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