Monetary policy and the zero bound : policy options when short-term rates reach zero

In response to continuing weakness in economic activity, the Federal Reserve has lowered its target for the overnight federal funds rate from 6½ percent to 1 percent over the past two and one-half years. Recently, concern has been expressed in the news media and among academic economists and policymakers that additional steps to ease monetary policy could cause the federal funds rate target to hit a lower limit of zero percent. In this event, it would not be possible to lower the target any further, and the Federal Reserve would have to alter its procedures for implementing monetary policy to provide additional policy stimulus. ; Sellon examines how monetary policy can be conducted when short-term interest rates reach the zero bound and whether policy is likely to be effective in this situation. He suggests that concerns about the zero bound as a constraint on monetary policy are greatly exaggerated. Even when short-term interest rates are near zero, central banks will generally have considerable scope to expand bank credit and to lower longer-term interest rates. And, in the event the banking system does not function effectively or long-term rates also reach zero, further options are available to provide policy stimulus. ; Sellon also examines two historical episodes—the United States in the 1930s and Japan over the past decade—that have been cited as examples of how the zero bound might reduce the effectiveness of monetary policy. He suggests that the central problem in these situations was not the existence of a zero bound per se but, rather, a weakened banking system that limited the effectiveness of monetary policy.