Do we need low interest rates or “more room to cut rates in the next recession”?

I periodically see claims that if another recession comes along the Fed would not have much room to cut rates further because of the zero lower bound.  Yet rates are still low, in nominal terms near zero and in real terms the short rates are negative.

True, if we ratcheted everything up in nominal terms with a four percent inflation target, maybe during the next recession the Fed could, by moving to a near-zero nominal rate, make short-term real rates negative three or negative four instead of a mere negative 1.5, or however the numbers would work out exactly.

Is that going to prove so beneficial?  I wonder.  I get that raising rates in bad times is harmful because of its contractionary impact.  I am far more skeptical that a short-term real rate of negative four is much more useful than a real rate of negative two.  How many investors have said “I won’t borrow at negative two but I will at negative four!”  Maybe some, but I wonder.  Just try to square that with a rational theory of private sector hurdle rates.

Keep in mind also that the Fisher effect does not work with any kind of one-to-one offset.  So raising the inflation target by two percentage points probably would not mean that nominal interest rates go up by two percentage points.  Nominal rates for instance might go up by only one percentage point.  And so when the next recession would come, there would still be room for a greater cut in nominal rates, but not by nearly as much as the boost in the inflation target.

So overall I am not so impressed by the “greater room to cut interest rates” argument for a higher inflation target.  That said, there are still other reasons why we might wish to have a more expansionary monetary policy in a recession.  But they are probably not interest rate arguments.


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