Australia and the Zero Lower Bound on Interest Rates: Some Monetary Policy Options

Abstract

Could 'it' happen here?Australia survived the global financial crisis relatively unscathed, despite much higher interest rates than in other developed countries (see Figure 1). But our exceptional status may be short-lived. In May 2015, the cash rate was cut to 2 per cent, the lowest level since the current series began in 1990, and by some measures the lowest short-term rate since at least 1960. Nevertheless, unemployment has risen steadily, despite the fact that investment in the resources sector has yet to fall back to normal levels.It would seem prudent, then, to be prepared for interest rates to approach zero, as has already occurred in most other OECD countries.2 Sheehan and Gregory (2013) and Freebairn and Corden (2013) have called for increased infrastructure spending on this basis. Yet, as these authors acknowledge, such a policy faces considerable challenges. Furthermore, if warnings of 'secular stagnation' have any validity, near-zero interest rates may not be a once-in-a-generation emergency to be dealt with using ad hoc expedients, but an increasingly common situation requiring a more systematic response. In this case, changes to monetary policy would appear more desirable.This paper considers various means by which monetary policy may stimulate aggregate demand when its usual instrument - the short-term interest rate - is unavailable. The objectives of monetary policy are taken here to be the conventional ones of a stable value of money and full employment, analysed under the broadly 'Keynesian' assumption that fluctuations in nominal spending have significant effects on real output. Financial stability objectives are assumed to be dealt with separately via (macro)prudential regulation.3The paper begins by describing the problem of the zero lower bound, and the logic of expectations management in general and level targeting in particular as a solution. It then argues, however, that level targeting requires a more careful choice of target variable than the current regime of inflation targeting, and that the price level, nominal GDP and nominal wages all appear problematic. A more eclectic mix of policies is then considered.The zero lower bound, and the vital role of expectationsAs long as money can be stored at negligible cost, interest rates cannot fall below zero, because hoarding money would then be a superior alternative to lending it. This poses a problem for conventional monetary policy, under which the usual response to falling inflation or rising unemployment is a lower interest rate. What happens if the interest rate cannot be cut any further? The experience of Japan in the 1990s, and much of the world since 2008, shows that near-zero interest rates are perfectly compatible with low and falling inflation, high and rising unemployment, and output well below previous estimates of potential.Can monetary policy still be effective in such a situation? Theory suggests that expectations management is the key. In the standard permanent income or life-cycle model, current spending is determined by expected future income and interest rates. If promises about future policy are successful in changing these expectations, they may increase demand without any immediate change in the central bank's balance sheet. Conversely, even a very large balance sheet expansion may be ineffective if it is believed to be temporary and thus does not change expectations.4 Krugman (1998), motivated by the then unusual experience of Japan, showed that, while a temporary monetary expansion would fail to raise prices and output at the zero lower bound (since it cannot change the current interest rate, and, being temporary, will not affect any future variables), a credible permanent expansion could work, by increasing the expected future price level and therefore reducing the real interest rate. (This assumes that a permanently higher money supply must eventually create proportionally higher prices at some point in the future when the interest rate rises above zero. …