I was lucky enough to be invited to a Bank of Canada conference on Thursday and Friday. The topic was "New Frontiers in Monetary Policy Design". One recurring theme in particular has stuck in my mind: that a credible promise to keep interest rates low for too long can help an economy escape a liquidity trap. (I apologise for not remembering which presenter or commenter expressed the point so clearly in this way that it stuck in my mind.)
It's not a new idea that expected future monetary policy, by raising the expected future price level, and so raising today's expected rate of inflation, can increase aggregate demand today. But expressing that idea in terms of keeping interest rates low for too long does give it a new perspective. We make commitments because by credibly committing to do something we would not otherwise want to do we can influence others' expectations today of our future behaviour. Rules vs. discretion. A central bank that can make credible commitments faces a trade-off between output today and inflation in the future. It will promise to create higher inflation in the future than it would want in future, in order to buy higher inflation, lower real interest rates, and higher output today. So if the central bank otherwise thought that 2% inflation is what it wants, it would promise to raise inflation temporarily above 2% as soon as it is able to do so. And of course it would want to renege on that prior commitment in the future, if it thought it could do so without harming its reputation thereafter.
Two unrelated thoughts come to my mind.
1. The Bank of Canada has said it would keep the overnight rate near zero for an extended period, conditional on the outlook for inflation. This is not the same as promising to keep the overnight rate too low so that inflation temporarily rises above the 2% target. It really amounts to promising to do what it would want to do anyway. That might be useful, in circumstances where others might be unsure what you want to do, or unsure what you currently think you will want to do in future, but it's not the same thing. But I can see the Bank's dilemma. It's credibility is so tied to trying to hit the 2% target, a promise not to hit that target in future is problematic. Promising to do something different from what you had initially promised to do does raise credibility issues.
2. The nightmare scenario. Making a promise to set nominal interest rates too low when we eventually escape the liquidity trap is all very well. But this assumes we eventually do escape the liquidity trap. What good is that promise if we never do escape? Of course, like all nightmares, this is daft. This too shall pass. But if we believed the logic of Neo-Wicksellian models, in which monetary policy is framed as setting the nominal interest rate, there can be no certainty that it will pass. Eventually the natural rate of interest will rise. But if by the time it does rise deflation and expected deflation are so strong, even a high natural rate might leave the equilibrium nominal rate negative. If people believe that a sufficiently high natural rate can break the deflationary spiral, then it can break the deflationary spiral. But if they don't, and deflation is already big enough to overcome any high natural rate, then it won't. And if we make the former, optimistic assumption, then why can't we get people to believe in high inflation right now, high enough to break the liquidity trap?
Dunno.
Worthwhile Canadian Initiative 
Jon,
You’re completely misunderstanding what I said.
The Fed’s OMO’s or other types of asset acquisition, when done with non-banks, create excess reserves and bank deposits liabilities. That’s exactly what I said:
“If the central bank acquires financial assets newly issued or sold by non-banks, the result is a dual balance sheet effect. Excess reserves increase. But so do bank deposit liabilities.”
By “bank deposit liabilities”, I meant commercial bank deposit liabilities, which I though was obvious. The non-bank seller of the asset deposits the central bank cheque in his commercial bank account, which increases money supply at that level.
Nowhere did I say anything to the effect that such intervention has some sort of effect on bank capital. And I’m quite aware bank capital is not an asset.
No, I understood what you said. I just took more comprehensive review…
I agree there are circumstances where excess reserves become a poor proxy (last October) but that arises because of special liquidity facilities wherein liabilities are owed to the Fed or sovereign rather than the public.
“Westslope: I think the issue is that while inflation can be either positive or negative (deflation), nominal interest rates can only be positive. Inflation is more desirable, as it allows greater flexibility with setting real interest rates, while deflation puts a lower bound on real interest rates that might be quite a bit higher than we’d like.” -Andrew F
Andrew F: Are you suggesting that we put the inflation rate at the service of the central bankers in hopes of making their jobs easier? In those circumstances, a little bit of price fuzziness is OK? Don’t central bankers already have sufficient tools to influence monetary events in addition to overnight rates?
With a central bank (CB) mandate limited to maintaining a stable price system, the impossibility of non-negative nominal rates would be unimportant. The “liquidity trap” would be relegated to the ranks of economic history. Maintaining central bank credibility would presumably be easier because the mandate would be rid of multiple, often contradictory objectives whose priorities are constantly being reassessed.
Is stable deflation really that scary? Let’s assume a CB policy target of -1% to 1%. The economy arbitrarily enters into a 5-year period where actual inflation is constantly -1%.
A risk-averse person saving money in a shoe box makes a real return of 5% over 5 years. A risk neutral person invests savings into a low-risk stock yielding a nominal 5% yield that is re-invested in the same stock. The real return after 5 years is 34% or 6.6 times more than the shoe box strategy. Add risk of a non-negative inflation rate and the attractiveness of hoarding cash diminishes further.
Would consumers delay some purchases? Perhaps. Many consumers already delay purchases in technological product cycles and nobody views that as a serious social problem.
If the consumer holds cash and waits 5 years to buy a consumer durable good whose price stays constant in nominal terms, the real savings amount to 5% off the nominal price. Would you delay a purchase or upgrade of a washing machine by 5 years in order to save 5% off the real price? Especially, if you as a consumer benefited from a significant surplus produced by services from the durable good? (Compare a washing machine to hand washing.)
Re: Japan. The current per capita GDP is ~US$35K in PPP terms and ranks globally at 22 according to the CIA. New Zealand figures in at US$28K and #49 in world ranking. Japan has a ways to go before crossing Newfoundland and China on the way down.
Adam P.
Re interest rates and debt repayments – good point indeed. Sort of a point about the difference between a dynamic view of the economy and an equilibrium view.