Low Interest Rates Worry the Fed. Ben Bernanke Has Some Ideas.

on Jan5
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SAN DIEGO — Ben S. Bernanke, the former Federal Reserve chair, said on Saturday that the types of extraordinary steps the Fed employed to help pull the economy out of the Great Recession should make up for the central bank’s limited room to cut interest rates in the event of another downturn — but that is contingent on a big “if.”

As long as the neutral interest rate — the setting at which Fed policy neither stokes nor slows growth — remains from 2 percent to 3 percent counting inflation, the Fed should be able to rely on tactics like snapping up bonds and promising to keep rates low in the event of another recession. But the neutral rate has been creeping lower for decades, dragged down by powerful and slow-moving forces like population aging. Should it continue to fall, the tricks Mr. Bernanke and his Fed used to coax the economy back from the brink in the 2007 to 2009 recession might prove insufficient.

In that case, “a moderate increase in the inflation target or significantly greater reliance on active fiscal policy for economic stabilization, might become necessary,” Mr. Bernanke said in a speech delivered in San Diego at the economics profession’s biggest annual meeting.

The Fed currently targets 2 percent annual inflation, a level it believes is low enough to allow for comfort and confidence on Main Street while leaving the central bank enough room to cut rates, which incorporate price changes, in a downturn. That target is meant to be symmetric, meaning that the Fed is equally unhappy if prices run below or above 2 percent.

Mr. Bernanke said policymakers should be able to compensate using a patchwork of other tools. They might eke out ammunition equivalent to 3 more percentage points of rate cuts by deploying mass bond-buying and promises to keep rates lower for longer, based on his analysis.

Such an approach “can largely compensate for the effects of the lower bound,” Mr. Bernanke said. He also said the Fed could keep other new tools in its back pocket, including by maintaining “constructive ambiguity” about negative interest rates.

“On one point we can be certain: The old methods won’t do,” he said.

America is not alone in running low on monetary ammunition.

Many advanced economies, including Japan and Germany, have seen interest rates slump lower as populations age, households and businesses save more and productivity slows. How much each driver matters remains up for debate. But what is increasingly obvious is some common force is at work.

As the change has taken hold, economists — and especially those at the Fed — have become increasingly concerned. The president of the Federal Reserve Bank of New York, John C. Williams, and his co-authors declared several years ago that shared global changes were likely driving rates lower.

Before long, their colleagues had estimated that lower policy interest rates could mean the United States will have rock bottom interest rates as much as one-third of the time.

Compounding the Fed’s problem, inflation has dropped lower. Price gains are incorporated into rates, so weaker gains mean less room to cut.

Under the leadership of the Fed chair, Jerome H. Powell, the central bank has been carrying out a review of its policy framework, researching and talking through how it might supplement its policy tool kit and keep inflation from drifting lower. That process is expected to wrap up in mid-2020.

In a blog post released Saturday, Mr. Bernanke endorsed arguably the most activist proposal aired to date, one laid out by a Fed governor, Lael Brainard, in a 2019 speech. Ms. Brainard suggested that the Fed commit itself to keeping rates lower for longer in advance, tying that pledge to the inflation rate, while also targeting rates on bonds with specific time horizons.

To be sure, the current situation is not all bad news.

In a world with lower inflation rates, for instance, the Fed can allow the unemployment rate to fall lower without worrying that prices will heat up too much, Mary C. Daly, the president of the Federal Reserve Bank of San Francisco, said on a panel at the gathering on Friday.

But that benefit comes at a potentially perilous cost. Inflation could slip dangerously low, as households and consumers come to expect weak gains and act accordingly — that seems to have happened in Japan. And if that happens, the Fed will have ever-less room to cut rates.

“Low inflation can become a self-perpetuating trap,” Mr. Bernanke said. “The costs associated with a very low neutral rate, measured in terms of deeper and longer recessions and inflation persistently below target, underscore the importance for central banks of keeping inflation and inflation expectations close to target.”

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