Economic Review
Fourth Quarter 2003 

Monetary Policy and the Zero Bound: Policy Options When Short-Term Rates Reach Zero
By Gordon H. Sellon, Jr.

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.

Globalization and Global Disinflation
By Kenneth Rogoff

Since the invention of money, pressure to finance government debt and deficits, directly or indirectly, has been the single most important driver of inflation. It is not at all clear, however, that improved fiscal policy has been the main driver of the recent disinflation.

Whatever the explanation of global disinflation, the raw data are stunning. In recent years, inflation around the world has dropped to levels that, only two decades ago, seemed frustratingly unattainable. If one takes into account technical biases in the construction of the CPI, as well as central banks’ desire to maintain a small amount of padding to facilitate relative price adjustment and avoid deflation, then disinflation has already run its full course in most industrialized countries. In the developing world, if current trends persist—with the emphasis on “if”—inflation will be tamed within a decade.

In a presentation at the Federal Reserve Bank of Kansas City’s 2003 symposium, "Monetary Policy and Uncertainty: Adapting to a Changing Economy," Kenneth Rogoff, professor of economics at Harvard and former economic counselor and research director at the International Monetary Fund, discusses whether the current situation can be regarded as stable into the indefinite future and whether the inflation process has changed fundamentally.

A New Era for Rural Policy
By Mark Drabenstott

Main Streets throughout the nation have depended on the perseverance of generations of small entrepreneurs. These rural entrepreneurs have also made big contributions to the national economy through the creation of companies like Caterpillar, Gateway Computer, and Pella Windows. Entrepreneurs may have an even bigger impact on rural America’s future.

Public policy will play a crucial role in shaping the environment within which rural businesses start and grow. Over time, the nation has reaffirmed the importance of helping rural regions grow their economies. The Rural Development Act of 1972 is one clear example. Since then, much has changed in the rural economy, signaling that new directions are needed for rural policy. Regardless of the direction, initiatives to help Main Streets grow more entrepreneurs will be a cornerstone of the new rural policy.

In testimony before Congress’s House Committee on Small Business, Drabenstott addressed four key questions concerning the future of U.S. rural policy. First, how has the rural economy changed over the past 30 years and what are the resulting challenges? Second, what are the best economic opportunities going forward? Third, what policy goals and framing principles will help rural America seize those opportunities? And fourth, what specific program areas are likely to make the biggest contribution to successful rural policy?

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