MNI POLICY: Early, Aggressive Fed Action at ZLB Most Effective

By Jean Yung

     WASHINGTON (MNI) - Early, aggressive use of quantitative easing and forward

guidance at the same time as the Federal Reserve cuts interest rates to zero

deliver the best dose of medicine for an economy facing a shock or recession,

according to research to be presented to the Federal Open Market Committee

Tuesday.

     "Stronger sooner" use of unconventional policies create impacts in less

than one year and can "substantially speed the recovery in the labor market and

support reflation," according to models developed by university economists

Janice Eberly, James Stock and Jonathan Wright.

     A discussion of the paper leads off the Fed's two-day academic conference

in Chicago to review its current framework or monetary policy. The FOMC is

expected to consider alternative inflation targeting regimes and take stock of

its suite of firefighting tools the next time it is faced with a crisis.

     The authors base their conclusions on an evaluation of so-called "slope

policies," including the Fed's use of forward guidance in meeting statements,

Summary of Economic Projections, and speeches by Fed officials after the

financial crisis, as well as the FOMC's large scale asset purchases and related

maturity extension program, otherwise known as Operation Twist.

     Normal Fed policy would have led to a fed funds rate of approximately -5%

after the Great Recession, but faced with the zero lower bound, slope policies

helped support the recovery, as well as offsetting roughly 1 percentage point of

the zero lower bound constraint, the authors found.

     The slow economic growth that has characterized the current recovery are

due to structural factors and government policies outside the Fed's control,

they added. Speeding up or delaying liftoff of the fed funds rate by one year

would have changed the unemployment gap by a few tenths of a percentage point,

and would have had a negligible effect on the inflation rate, they said.

     --TEMPORARY PRICE LEVEL TARGET

     The study also simulated a version of temporary price level targeting in

which the Fed committed to maintaining very accommodative policy starting in

2008 and until inflation over the previous year had averaged 2%.

     That policy, without the use of additional forward guidance or quantitative

easing, would have resulted in the Fed's lifting off from near-zero rates in

2018 instead of 2015, slightly higher inflation and a slightly faster falling

unemployment rate. But the difference is small, as "the disinflationary forces

from the recession were too big to be easily addressed by level shocks alone,

even with temporary price level targeting," the authors said.

     Adding unconventional tools to the mix enabled a faster recovery and

liftoff in 2012, however the technical aspects of the model may hinder the

reliability of the simulated results as they do not take into account shifts in

inflation expectations, the authors said.

--MNI Washington Bureau; +1 202-371-2121; email: jean.yung@marketnews.com

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