Scott Sumner  

The implications of zero interest rates for monetary and fiscal stimulus

Henderson at Susquehanna Unive... Thumbs Up for "The Interview"...

There is probably no issue in macroeconomics that is more misunderstood than the zero interest rate environment. Let's go over some of the misconceptions:

1. Most people correctly understand that the zero bound is bad news for monetary stimulus, but they don't know why. They think it's because monetary stimulus works through lowering interest rates, and nominal rates cannot be cut significantly below zero. In fact, monetary stimulus is easy to do at the zero bound, just peg NGDP futures contracts at a price 5% above current NGDP and your policy will be expected to succeed. In all likelihood no QE will be needed.

2. So why do I say zero rates are "bad news" for monetary stimulus? Because they represent a market prediction of slow NGDP growth. Thus for policymakers to succeed in creating fast NGDP growth, they must do more than the market expects. But the market forecast is probably the best forecast of what policymakers are likely to do. Markets understand the mindset of policymakers, and have a pretty good grasp of how they are likely to react to a given situation. When rates are zero, we should all rationally expect failure.

3. Many people don't realize that zero interest rates are also bad news for proponents of fiscal stimulus, as near-zero rates represent a rational bond market forecast that whatever fiscal stimulus is done will be inadequate. A good example occurred in November 2008, when Obama's fiscal stimulus failed to boost the economy, or the markets. You might be thinking, "wait a minute, I thought Obama's stimulus didn't take effect until well into 2009." If you were thinking that, you haven't kept up with the latest New Keynesian models. A change in fiscal policy occurs when there is a change in the expected future path of fiscal stimulus over time. Thus an expected future tax cut is expansionary right now. So the collapse of nominal interest rates in late 2008 and early 2009 was a prediction that the expected Obama fiscal stimulus would be inadequate. My hunch is that this is why Paul Krugman insisted the ($800 billion) stimulus proposed by Obama was too small---he read the market tea leaves. If it had been $1300 billion he still would have said it was too small.

4. This leads to the next point. Many people believe that monetary and fiscal policies are there to "fix problems." No, they are there to prevent problems. Aggregate demand problems occur precisely because markets expect policymakers to fail to generate adequate growth in aggregate demand (historically about 5%/year, although perhaps 4% today.) If there's a problem to be fixed, it means you've already failed to do your job. Lags are not the issue, if markets had expected adequate stimulus, even after a modest lag, they probably would not have crashed in late 2008 and early 2009. Instead of lags, the real problem is that the markets correctly saw that adequate stimulus will not be forthcoming, even after a lag. You need a rules-based regime in place to prevent problems, don't expect to grab a monetary or fiscal stimulus tool as if you are pulling a hammer out of the tool shed---it will be too late.

5. Many people are dismissive of monetary stimulus at the zero bound on the grounds that it relies on the "expectations fairy." As noted above, you still have the option of pegging NGDP futures prices. But these critics also fail to perceive that fiscal stimulus is equally dependent on the expectations fairy. Japan has run big fiscal deficits for 20 years, and had falling NGDP---one of the worst growth rates of aggregate demand in all of modern world history. How can that be? Very simple, expectations of deflationary BOJ monetary policies prevented the fiscal stimulus from boosting current AD. Just because the Japanese government gives out a tax rebate, the public isn't going to run out and buy new houses if the BOJ's deflationary monetary policy is expected to drive house prices relentlessly lower. To work, fiscal policy must be accompanied by an expansionary expected future monetary policy. But if you have that, why bother with fiscal?

The big mistake in all this is thinking of low interest rates as a sort of "easy money tool." In contrast, recall that Milton Friedman said low rates are a sign that money has been tight. If you reverse the standard view of cause and effect you won't always be correct, but you'll be right far more often than if you think low rates are easy money. Suddenly it will make sense that Brazil has high inflation "despite" high interest rates. Or that the US had deflation and falling RGDP in the early 1930s "despite" low and falling interest rates. Most of the public and even most economists look through the wrong end of the telescope.

Start thinking of expected NGDP growth as the monetary policy, and nominal interest rates as the effect of that policy. Then you can avoid the following trap: Many people think that if the Fed and BOJ have already cut rates to zero and done QE, just imagine how much more they'd have to do to get fast NGDP growth. In fact, those countries that do "enough," like Australia, do not have zero rates and lots of QE, precisely because their policies did not fail. They appear to do very little.

PS. I've retired from teaching at Bentley University and will devote myself full time to promoting the sort of ideas expressed in this post. Through a very generous donation from Kenneth Duda, I'll be directing a program on monetary policy at the Mercatus Center. I have a much longer post at TheMoneyIllusion that provides additional details.

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COMMENTS (17 to date)
Todd Ramsey writes:

This is an honest question seeking an honest answer: Is it possible, or even likely, that markets in late 2008 were pessimistic because they feared a large increase in government spending and/or regulation? That markets believe fiscal stimulus is likely to reduce, rather than increase, GDP?

Tom M writes:

Another excellent response to some of the comments of late. I always like to think of interest rates through the lens of the Fisher Equation:

i = r + \pi^e
Nominal Rate= Real Rate + Inflation Expectations...

The Fed can control nominal rates and inflation expectations. Most people assume that when Nominal Rates have reached zero (Zero Bound problem) the Fed can no longer have an effect on nominal growth. However, through inflation expectations, the Fed can still be highly effective at the Zero bound, it only takes a commitment on there part.

A nominal GDP peg is perfect is this case because it removes some of the work load off the Fed (if markets expect the Fed to remain committed to that target, they will adjust without the Fed having to do QE, forward guidance,etc.)

P.S. Congratulations on the new Job, very exciting stuff. You will be missed at Bentley I am sure.

Scott Sumner writes:

Todd, I suppose anything is possible, but I doubt that (at least in terms of GDP.)

More plausible is that the stock market was pessimistic because they thought a depression would lead to anti-business policies. Of course stocks have done very well since, so if that was their fear it was greatly exaggerated.

Thanks Tom.

Joe writes:

"A good example occurred in November 2008, when Obama's fiscal stimulus failed to boost the economy, or the markets"

Is this a typo?

Obama wasn't inaugurated until Jan. 2009.

Joe writes:


I'm dumb.

RPLong writes:

Congratulations on the new career developments, and best of luck!

I thought #4 above was a great point, but overall I chuckled a little because this post reminded me a lot of Ayn Rand's essay, Egalitarianism and Inflation, specifically her "proof" that the "precondition of inflation is psycho-epistemological--that inflation is hidden by perceptual illusions created by broken conceptual links".

I know it's uncool to cite Rand, but you gotta admit that it is at least kind of funny.

Ray Lopez writes:

To be persuasive you must anticipate your opponents replies, like a game of chess. Take a look at the comments in today's "Can the inflationary erosion of G lead to austerity?" Basically you have a lot of smart people (and not me either, it's not my field) wondering what this sentence means: "NGDP is a direct test for AD shocks, whereas RGDP can be impacted by either AD or AS. RGDP doesn’t show AD changes, it shows aggregate quantity demanded. RGDP rose in the US between 1865-96, was that more AD, or more quantity demand as supply rose?"

And to answer the 1865-95 question, see The Grumpy Economist Jan. 8 graphic, which shows probably the answer is 'both' to the last question, though arguably it's more supply created more demand, a sort of Say's Law.

TallDave writes:

So here's a notion: even supposing liquidity traps really exist, and the Fed could buy up the entire national (and perhaps municipal) debt and still not move inflation... in that case, why wouldn't we want it to do just that? Fed profit is returned to the federal government, so it amounts to retiring the national debt, at least until such time as the Fed needs to sell them to reduce money supply.

Fascinating to consider the ramifications -- essentially, investors would be proclaiming "Our collective belief in the Fed's inflation-fighting commitment is so puissant that the CB can dump enough money to pay the national debt into the system and higher long-term inflation is still not credible."

The Fed should target the NDGP trend, and not shy away from doing absolutely everything it has to in order to make the target credible.

J Mann writes:

TallDave - I said something like that a few years back. I didn't look at the market psychology so much as the idea that I would have a much easier time accepting fiscal stimulus after we retired the debt.

I guess one possible argument is that there's a tipping point out there somewhere - that once we express an intent to print too much money, market confidence will collapse catastrophically, but until then, effective monetary stimulus is essentially impossible.

RPLong writes:

TallDave / J Mann - Similar to Murray Rothbard's idea about repudiating the national debt, right?

TallDave writes:

J Mann -- one expects the tipping point would occur when something changed expectations about the Fed's future behavior. So if the Fed could retire the national debt today, that is only because markets do not believe the CB would continue to do so in the future irrespective of fiscal policy (sorry MMT!).

Of course it should be emphasized they might easily need to sell them again at some point, possibly long before the debt was "retired."

FWIW, they currently hold $2.4T in Treasuries, of the $17T debt, and $1.7T of MBS, which seem to comprise the bulk of their $4.4T in total assets (assuming I am understanding FRED).

fralupo writes:

I guess if I thought there was no such thing as an exogenous shock to the economy I'd think this too.

Where is the role for private enterprise, technological development, management miscalculations, resource discovery & exploitation, etc. in this model? Is everything the private economy does just a response to actual or predicted public policy?

I'm reading this as saying that at the zero bound everything that can happen is exclusively the result of government action or anticipation of government action. If I tried to tell you that interest rates were purely determined by public officials (or could be expertly manipulated if those officials were on their game enough) I'd hope you'd at least bring up supply and demand or something.

ThomasH writes:

1) In fact, monetary stimulus is easy to do at the zero bound, just announce a policy of buying more and longer term bonds until you hit the "dual mandate of full employment without average inflation having increased. Whether this is "easier" than announcing an NGDP futures target or a higher PLT is another matter. There is nothing technically "hard" about it, but there has been fierce opposition from a portion of the business community and Republican politicians.

2) Being at the ZLB indeed represents a view that real growth will be slow; that’s pretty close to a definition of a recession. I do not see why that view is a problem for policy. The monetary authority can still meet whatever target it chooses if it is willing to do so and is not constrained politically from taking action.

3) This depends on what one means about fiscal policy. Public investment is supposed to be made in projects that have positive net present values. At full employment and high borrowing costs many project do not make the cut. During recession when some resources have market prices greater than their opportunity cost and borrowing costs are low investment automatically rises. I guess you could call this investment rule a “policy,” but is seems more reasonable to call the refusal to invest in positive net present value projects a policy, “austerity.”

4) Agreed that prevention is better than a cure, but at any given moment it is not clear that adoption of the proper policy rule for the future is all that needs to be done at that moment.

5) Many people are dismissive of monetary stimulus at the zero bound on the grounds that it relies on the "expectations fairy." I have not heard that one. I think, rather, many people dismiss “monetary policy” based on an assumption that monetary authorities are politically constrained from taking the actions that would be necessary. The period 2008-2014 has shown this to be a pretty good but fortunately not entirely correct assumption. Perhaps announcing an NGDPLT would prevent this constraint from ever becoming binding. It's worth a try.

Lorenzo from Oz writes:

This is an enormously clarifying post, thank you. The "expectations fairy" arguments have always struck me as a little odd, since the only thing we have regarding the future are expectations (derived from present and past experience). But if you have an underlying view of the economy/society as "social mechanics" rather than a coordination problem of agents, perhaps that point does not strike with much force.

Duncan Earley writes:

Hi Scott, could you make more comment on what you think Australia did right? Despite being an Australian I oddly tend to follow US Fed policy more closely.

Scott Sumner writes:

RPLong, That's funny.

Ray, The point is that prices fell significantly over that period, which suggests it was mostly supply increases boosting quantity demanded.

TallDave, That would be great news. America could buy all of the global wealth, and then we could sit back and live off the hard work of other countries.

Unfortunately . . .

fralupo, Not sure who that's addressed to, but I am very critical of the Keynesian view that only AD matters at the zero bound. Supply matters too. You might want to check my questions for Keynesians over at

Thomas, You said:

"In fact, monetary stimulus is easy to do at the zero bound, just announce a policy of buying more and longer term bonds until you hit the "dual mandate of full employment without average inflation having increased. Whether this is "easier" than announcing an NGDP futures target or a higher PLT is another matter. There is nothing technically "hard" about it, but there has been fierce opposition from a portion of the business community and Republican politicians."

It can't be that hard because the Fed was so successful that they were able to taper and are now about to raise rates. I think they have the wrong target, but they certainly hit their target.

2. Being at the zero lower bound is a prediction that policy will fail. That's very worrisome.

3. When I refer to fiscal stimulus I am talking about projects not justified on standard cost-benefit grounds, only when the (assumed) multiplier effect kicks in.

5. You may not have heard of that one, but it is an extremely common complaint.

Thanks Lorenzo.

Duncan, They kept NGDP growing. How did they do this? Perhaps because they avoided the zero bound, due to a higher trend rate of NGDP growth (reflecting a higher inflation target and faster trend RGDP growth.

Jeff writes:


This is one of your best EconLog posts ever. I hope you can get a wider audience in your new position, for which I offer my belated congratulations.

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