Monetary Policy at the Zero Lower Bound: Discretion, Uncertainty, and Interest Rate Volatility

The Bank of Japan has contended with the zero lower bound on monetary policy for almost three decades.

Mark Wilkinson is a graduate of the MPA in Public and Economic Policy from the London School of Economics. During this degree, he carried out Capstone research for the Bank of England on administrative data in central banking and wrote his dissertation on monetary policy (the latter being the paper covered here). Mark has recently worked for the International Growth Centre as a copy editor for policy briefs, and he will soon join the Federal Reserve Board in Washington DC as a Research Assistant in the Money Market Analysis section of Monetary Affairs.

Mark’s paper, Monetary Policy at the Zero Lower Bound: Discretion, Uncertainty, and Interest Rate Volatility, is published in the 2017 edition of The Public Sphere, available to read online here. This piece is part of a series of articles contributed by authors featured in this year’s issue.


In an era of near-zero nominal interest rates in many advanced economies following the global financial crisis, and with little aid from fiscal policy, what is the most effective way to use monetary policy to spur economic recovery?

Central banks lower their policy interest rates during periods of economic weakness to stimulate economic output and inflation, so, the zero lower bound (ZLB) on nominal interest rates hinders central banks’ abilities to use monetary policy to kick-start economic recovery. In my paper published in the Public Sphere Journal, I study optimal monetary policy at the ZLB under a set of further constraints on central bank policy making: uncertainty about future economic activity, the central bank’s inability to make credible commitments beyond the short term, and welfare losses from interest rate volatility. The objective of this study is to specify the characteristics of optimal monetary policy under these conditions in a standard New Keynesian dynamic stochastic general equilibrium model.

The chief problem of the ZLB is that setting interest rates below zero means lenders must pay to keep their money in a bank. Lenders would prefer to hold paper currency in this situation, earning no interest, rather than deposit it in banks for a fee. Consequently, central banks cannot push the policy rate significantly below zero. This dynamic is known as a liquidity trap, since the conventional policy of expanding liquidity through monetary easing becomes impotent. The ZLB has proved a serious constraint for the Bank of Japan since the late 1990s and for many other central banks since the financial crisis of 2007-2008, notably including the Federal Reserve and the European Central Bank.

Setting interest rates below zero means lenders need to pay to keep their money in a bank. In this situation, lenders would rather hold cash rather than deposit it in banks for a fee. This can lead to a liquidity trap, in which conventional policies of expanding liquidity through monetary easing are ineffective.

The natural interest rate is a proxy for economic activity because it is the equilibrium real (i.e. inflation-adjusted) interest rate that is consistent with stable prices and full employment. With uncertainty about the natural rate, there is a higher chance that the ZLB will bind again in the future. The lack of central bank credibility about long-term policy actions implies that investors view the central bank as a discretionary actor — effectively prepared to renege on its previous commitments — so investors do not change their expectations based on central bank commitments.

In this situation, there are asymmetric risks weighted toward the downside in the setting of monetary policy. Unconventional monetary policies—in the form of large-scale asset purchases and forward guidance—are imperfect substitutes for the constrained traditional policy rate. A trade-off results between keeping interest rates lower for longer to ensure economic recovery and beginning to raise rates earlier but more gradually.

In my research, I augment the social welfare criterion, used to judge the desirability of alternative policies, to assess whether a policy rate path that remains lower for longer is excessively volatile when it finally leaves the ZLB. Given the deflationary bias of purely discretionary policy at the ZLB, in some simulations I introduce a so-called Rogoff ‘conservative’ central banker that places a much higher value on inflation stabilisation than output stabilisation.

My central finding is that an optimal discretionary policy augmented to account for uncertainty about the natural interest rate forcing the ZLB to bind can perform as well or better than a standard monetary policy rule (here, two variants of the Taylor rule). The discretionary policy achieves this lower welfare loss by remaining at the ZLB for a median of 2 quarters or a mean of 3.6 quarters longer, even though it has a more volatile rise when it does increase the policy rate. Concerns about the volatility of policies that remain at the ZLB longer are not supported by the model, nor are concerns that such policies would be unable to respond to a burst of inflation.

An addendum to these findings is that the appointment of a Rogoff-type central banker may help discretionary central banks increase inflation back to target during a liquidity trap, with the caveat that there is high policy rate volatility. In sum, this study implies a need for heightened central bank risk management near the ZLB and a lower policy rate until the recovery advances further and the risk asymmetry moderates.

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