Pitfalls of Makeup Strategies for Mitigating the Effective Lower Bound.

• Author: Levin, Andrew T.

During the last U.S. recession in 2007-2009, the Federal Open Market Committee (FOMC) reduced the target federal funds rate by about 5 percentage points, and that target was maintained near zero--the FOMC's assessment of its effective lower bound (ELB)-for about seven years thereafter. The funds rate has subsequently been lifted above the ELB but currently stands at around 1.5 percent (as of late 2019) in a context of moderate U.S. growth, subdued inflation pressures, and a turbulent global environment. Thus, an increasingly urgent question is how the Federal Reserve would provide sufficient monetary stimulus in the face of the next adverse shock that hits the U.S. economy. (1)

The minutes of recent FOMC meetings indicate that policymakers are now actively considering the possibility of adopting a so-called makeup strategy for mitigating the ELB. Such a strategy entails a commitment to maintain an accommodative stance beyond the timeframe over which the ELB is binding, thereby inducing an elevated period of inflation to "make up" for previous inflation shortfalls. As noted in the FOMC minutes, however, the effectiveness of a makeup strategy "depends on the private sector's understanding of the strategy and on their confidence that future policymakers would follow through on promises to keep policy accommodative." (2)

Indeed, published transcripts from FOMC meetings in 2011-2012 indicate that such concerns were crucial to the FOMC's discussions about how to frame its forward guidance at that juncture. For example, at die November 2011 FOMC meeting, William Dudley (then serving as president of the Federal Reserve Bank of New York and vice chair of the FOMC) emphasized that the FOMC's calendarbased forward guidance was merely a projection, not a commitment, noting that "making binding commitments might be viewed as potentially reckless in a world where the outlook is highly uncertain."

At die same meeting, Janet Yellen (then serving as Federal Reserve Board vice chair) indicated:

We need to be mindful of the intrinsic limits on our ability to make credible promises over time horizons that extend beyond several years. We need to follow a pragmatic approach for promoting the stability of economic activity and inflation, recognizing the limits of our understanding of the stmcture and evolution of the economy and of our ability to anticipate or plan for all possible contingencies. Finally, Elizabeth Duke (a Federal Reserve Board member) also underscored the hazards of making commitments about the FOMC's future policy actions, noting:

The public could focus on the potential for the rotation of voters to change the path or the potential for the two open seats and the upcoming term endings on the Board to bring about a philosophical change or, in the worst case for credibility, the political debate could become fixated on effecting such a change through legislation or personnel changes. (3) Unfortunately, such concerns cannot be readily addressed in the Federal Reserve Board's workhorse macroeconomic model, known as FRB/US. That model was developed and launched in the mid1990s and has undergone only modest changes since then, including revisions to the wage and price equations in 2014 and some further streamlining in 2018. (4) Simulations of the FRB/US model are limited to one of two assumptions about how households, businesses, and financial market participants form their expectations of future monetary policy: (1) vector autoregressions (VARs), which imply that FOMC forward guidance about its policy strategy has no effect whatsoever; or (2) model-consistent expectations, which imply that the private sector has a complete understanding of the dynamic behavior of the economy (as captured by the FRB/US model itself), and that the FOMC's policy strategy is completely transparent and fully credible. (5)

In this article, we examine the effectiveness of makeup strategies, drawing on a burgeoning academic literature regarding the "forward guidance puzzle" as well as our own work on this topic. (6) Our analysis highlights three specific pitfalls of makeup strategies: (1) the impact of forward guidance is diminished in models with plausible assumptions about the private sector's expectations formation; (2) the effectiveness of such strategies is likely to be further attenuated by the imperfect credibility of policymakers' commitments; and (3) policymakers' ability to make a firm commitment to such a strategy may be hampered by model uncertainty--that is, their own imperfect knowledge of the dynamic structure of the economy.

Expectations Formation

During the 1990s and 2000s, analytical studies of monetary policy in New Keynesian (NK) models were generally conducted under the assumption of model-consistent expectations (MCE), often referred to as "rational expectations." For example, Goodfriend and King (1997); Rotemberg and Woodford (1997); and Clarida, Gali, and Gertler (1999) analyzed optimal monetary policy in small stylized NK models, and Eggertsson and Woodford (2003) extended that approach to consider the implications of the ELB. Such methods were subsequently employed in analyzing optimal policies in the MCE version of the FRB/US model as well as the dynamic stochastic general equilibrium (DSGE) models in use at many odrer central banks. (7)

However, subsequent analysis by Del Negro, Giannoni, and Patterson (2012) pointed out that conventional NK models had utterly unrealistic implications regarding the potency of forward guidance at long time horizons--a finding referred to as the "forward guidance puzzle." In particular, a transitory nominal interest rate cut announced far in advance--say, 5 or 10 years in the future--generates markedly greater stimulus than if that same rate cut were implemented immediately. This result hinges on the MCE assumption (i.e., the central bank can make announcements about future monetary policy with full transparency and credibility) as well as other structural assumptions embedded in conventional NK models.

Thus, a burgeoning academic literature has succeeded in formulating a new vintage of NK models in which the forward guidance puzzle is substantially diminished or resolved. (8) Some of the most prominent contributions to this literature include:

* McKay, Nakamura, and Steinsson (2016)...